Building a home from the ground is complicated and opposite to buying a home. You start from scratch and contribute your time and money to every brick in the house. However, house construction doesn’t mean always building from the start. You can upgrade from your current home or undergo a complete renovation. A short-term construction loan is more appealing due to the low housing inventory. The home construction loan covers the price of the land, labor costs, building materials, and permit fees.
Instead of the lump sum upfront, you receive the fund as the construction process continues. You can actualize the vision of a dream home at every step of construction. You find your expression in the ideal location, with the right floor plan, tiles, cabinets, backyards, terrace, and everything in the home. Unlike buying a ready house, you don’t have to compromise with any house feature.
The lender disburses the money in installments at each stage of the construction process. The home buyers only need to pay interest on the construction line of credit until the home is built. Once the construction period ends, the construction loan is converted to a traditional mortgage loan for a home. The loan term for the mortgage is determined before the construction ends.
The home construction loan is converted to a mortgage loan for the house, so the buyer has to work with the same lender from start to finish. There is no fixed tenure. You can conveniently convert your construction loan balance to a 30, 20, or 15-year standard mortgage.
You can get a home construction loan on attractive terms if you have a high credit score. There are other eligibility criteria and document requirements that you have to submit for paperwork like KYC documents, a license certificate from the builder, a detailed plot of the house design, a land ownership document, building permission, etc.
Construction loans offer possibilities to finance your building project and refinance your complete building altogether.
Types of Construction Loans
Several types of home construction loans are available for house building or renovation projects.
Construction-to-Permanent Loan
The construction-to-permanent loan is also called a one-time closure loan. It is a single loan that offers a one-time closing of all your construction aspects. It is converted to a permanent mortgage for a home loan when the building is complete; until then, you have to make interest-only payments. The interest rate will be the same, and you have to pay closing costs only once. However, this type of loan could be more expensive than traditional mortgages. Also, it’s harder to qualify for because you have to approve it from local municipalities and the builder’s cooperation.
Construction-only Loans
The construction-only loan is a two-time closure loan. It has two separate loans under one approval. This loan covers only the expenses associated with the construction process. The borrower must close the construction loan when the loan is complete and then the permanent mortgage. You get a slightly higher rate for the short term, but when the construction is completed, you can refinance your home value for a mortgage loan.
Renovation Loans
Renovation loans, or FHA 203(k) loans, are insured by the Federal Housing Administration (FHA). The construction loan for renovation is ultimately turned into a mortgage loan after closing. The refinancing depends on the home’s value after the renovation is completed. Conventional loan borrowers may qualify for these loans. You can have a long-term fixed-rate mortgage or an adjustable-rate mortgage. And also, there is an additional closing costs incurred to convert the loan.
You can opt for this loan if you need more cash for the remodeling and repair work. You can consider a few low-down-payment renovation mortgages like HomeStyle loans, CHOICERenovation loans, FHA 203(k) loans, USDA renovation loans, etc., to refinance a current mortgage for remodeling project costs.
Why Do We Require Construction Loans?
When you’re building a new home, you dont need to possess any value assets at that time. You can apply for a construction loan, but the lender will closely examine architectural plans, budget, contractors, materials used, and your financial status to ensure the return. The construction loan approval process could be more rigorous, but you can customize the house as per your checklists. You don’t need to make costly repair or upgrade on ready-to-move home.
You can build a home to your specifications, like an open floor plan, kitchen design, granite countertops, walk-in closets, large bathroom and bedroom, large terrace, and plenty of storage space. You can install energy-efficient appliances and high-efficiency insulation in refrigerators, washing machines, water heaters, furnaces, and air conditioners to reduce electricity costs.
Because everything is built from scratch, no repair and maintenance costs are involved, at least for the initial years. Wall, plumbing, electrical, alarms, etc will work until the warranty expires. Your constructed home allows you to incorporate safety and environment-boosting measures in your new home.
Construction Loan Process
Before going for a construction project, it’s crucial to understand how a construction loan works. Instead of transferring the lump sum, the construction loan is disbursed in phases. When the house construction is completed, and you get the certificate of occupancy, you can convert the construction loan into a mortgage loan.
So, the construction loan works in two parts. The first part is a short-term loan lasting for a year, and you have to pay interest only during construction. You may require a higher down payment, a lower debt-to-income ratio, and a higher interest rate for short-term payments.
Consult a construction loan specialist to identify your financial needs and what type of construction loan suits you best. You should keep some contingency funds for an unpredictable future in addition to a down payment and closing costs.
You will get smaller payments or draws with each process stage. The construction inspector visits the site and inspects the progress to release the construction funds accordingly.
The different draw phases are:
- Foundation complete
- Rough framing like a roof, exterior doors, and windows complete
- Electrical Plumbing, HVAC, insulation, and drywall, complete
- Interior fixtures, doors, cabinets, and countertops are complete
- Exterior finishes, walkways, and driveway are complete
- Hard surface flooring siding is done, and exterior grading is complete
- Certificate of Occupancy issued
Once the construction is completed, the home construction loan is rolled into a mortgage loan for a home. You can pay the standard mortgage over 10 – 30 years, depending on your chosen tenure.
Remember, two loans mean 2-sets of closing costs; however, you can combine the construction loan and permanent mortgage into one easy closing, making it much more accessible and affordable. If you pay the closing cost at the beginning, you can save two times closing costs.
How are construction loans available for home renovations?
You can use a house renovation loan to modify, renovate, or upgrade your home. You can use your home equity to pay for renovations with a Home Equity Loan. The amount for a renovation depends on your home equity value. The lender approves your renovation plan and the money in installments. You can also refinance your home value and spend the cash on repairs and renovation.
Conventional loan borrowers may qualify for renovation loans through Fannie Mae (HomeStyle Renovation) and Freddie Mac (CHOICE Renovation). The Federal Housing Administration (FHA) issues renovation loans, which you can use for purchase and renovation and pay a monthly mortgage. Plenty of financing options come with longer loan tenures and attractive interest rates that you can use for expansion or renovation projects.
How do construction loans differ from mortgage loans?
There are several key differences between a construction loan and a mortgage loan. The fundamental key difference is the length of the term. The construction loan suffices for 12- or 18-month construction periods. On the other hand, traditional mortgages are long-term loans and usually go for 15-30 years. The borrower receives the lump sum in the mortgage loan, while the construction loan is released in draws in the construction phases.
Construction loan in interest-only payment until the construction is complete, so you don’t have any burden on your budget for the first year. A mortgage loan doesn’t give that relief; you must pay the principal and interest from the start. However, you have to repay with a fixed rate. The construction loan may have variable rates depending on the lender and what type of construction loan you have.
If you approach the right mortgage lender for a one-time closing and fixed rate from the start of your construction project, you can reduce your stress regarding variable rates and 2-time closing. The down payment for a construction loan is another concern, as it is slightly higher than the conventional mortgage loan. When you are looking to construct or buy a home, compare the loan terms, interest rates, and down payment, and for better understanding, take guidance from an expert mortgage company for making sound financial decisions.
PrivaMortgagae offers a single-close option for a combined construction loan and mortgage in one loan. Comparatively lower down payment and one-time fixed interest rate for closing give you enough room to stretch your arms. You can refinance your home value for renovation or mortgage payments with several refinancing options. If you own a land, you can refinance your land’s value for the down payment. PrivaMortagage assists you at every step of your home construction journey and streamlines your house-building process.
Check Construction Loan Rates
Construction loans usually have variable interest rates. The introductory interest on construction loans depends on your credit score and low debt-to-income ratio. You can get up to 100 percent of the construction value as a construction loan, But the risk will be high on the lender. Traditionally, the home construction loan has a high rate, but a single closing of construction and mortgage loan reduces your closing cost and detrmine your interest rate for your loan term. And you have several refinancing options to encash your property value to meet the mortgage.
Before applying, you can use the mortgage calculator to get a general idea of your home mortgage budget on various loan amounts, tenures & interest rates. The interst rates on construction loans vary according to credit score, monthly income, occupation profile, employer’s profile, and loan amount. The floating interest rate increases uncertainty and stress. Though you can have lower interest rates, the initial down payment contribution will increase.
How to get construction loan approval for a home
Similar to a standard mortgage, the construction loan also has some eligibility requirements, but the process is more stringent than a mortgage home loan. The construction loan approval process is lengthy because it doesn’t have any collateral, so the rigorous checking of applications is necessary to avoid any risk later.
The existing home loan borrowers and new customers are eligible for home construction loans. You need a good credit score of 620 or higher to qualify for a construction loan. The lender needs proof of income, bank statements, employment history, and credit history.
The best practice is to take some additional cash reserves for unforeseen delays and cost overruns. The lender also sees your house’s building plans, specifications, and blueprints and examines the builder to ensure they are licensed and insured. The lender also analyzes whether the proposed budget plan is reasonable for the house. Discuss your long-range goals and lifestyle requirements with your lender before deciding.
Closing Thoughts
Generally, construction loans are at higher risk for lenders than conventional mortgage loans. If you default on a mortgage payment, the lender has the house as collateral, but for a construction loan, the lender has only a partially built home, which it cannot even refinance.
The construction loan comes with higher interest rates and short terms. The 12-18 month duration is short but allows you to realize your dream home. Carefully consider the timeline, processes, additional fees, and potential delays, and choose the lender that offers low-interest rates and fees and guides you at each step of the construction process.
