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How To Get A Home Loan To Build A House: The Essentials About Construction Loans

A Crash Course On Construction Loans
Written by
January 19, 2023
/
6
min read

We all have a vision of our dream home. But some people take it to the next level, dreaming up their future homes down to the last detail. If you're in the latter bunch, then you may know by now that house hunting can often be unsatisfying. After all, purchasing a home is a huge investment.

However, financing a home that has yet to be built is not quite the same as taking out a traditional mortgage. Here, we'll walk you through everything you need to know about construction loans to start turning your dream home into a reality.

Understanding The Construction Loan

A construction loan, also known as a self-build loan or a construction mortgage, is a short-term loan used to finance a home construction project. Short-term means these loans last no longer than one year. These loans are also offered at a higher interest.

How Is A Construction Loan Different From A Traditional Mortgage?

There are a few key differences between traditional home loans (or mortgages) and construction loans:

  • Higher interest: Because there is no existing home yet, lenders have no collateral in the event the borrower cannot repay the loan.
  • More requirements: Creditors need to make sure their money will be budgeted properly. As such, they require detailed documentation of plans, including a construction timeline and estimates.
  • Interest-only payments: During the construction period, borrowers make interest-only payments. Instead of monthly payments, a borrower gets an appraisal during various stages of construction, then pays in "draws". Interest is charged only on the amount drawn.
  • Higher down payment: Again, this has to do with the risks involved with financing something that doesn't exist yet. Government-backed home loans can require as little as three to five percent down payment, while construction loans may require up to 25 percent.

What Does A Construction Loan Cover?

A construction loan will cover the following costs:

  • Materials: This involves everything needed to build the home, from roof framings to paint.
  • Labor: This covers the cost of hiring a contractor and all the staff needed to complete the project.
  • Interior finishings: Lighting fixtures, plumbing, trim, space division systems, and the like are all covered by a construction loan.
  • Permits: This includes all the necessary paperwork required to build a house, such as electrical, plumbing, roofing, and fence permits.

A construction loan does not cover furnishings or items that can be moved, such as decor and appliances.

The Types Of Construction Loans

Before taking out a construction loan, make sure you know the difference between them:

1. Construction-To-Permanent Loan

Also known as a C2P loan, one-step loan, or a single-close loan. This type of loan provides borrowers not only with the funds needed to build their homes but to finance a permanent mortgage as well.

In essence, the lender provides the funds to complete your home. Once it is built, the loan is converted into a permanent mortgage. This conversion process is called refinancing or modification. With a C2P, borrowers avoid paying closing costs and down payments again.

2. Construction-Only Loan

As its name suggests, this loan covers the cost of building a new home. However, once the house has been completed, you'll need to secure another mortgage to cover the cost. This means another round of closing costs and down payments.

3. Home Renovation Loan

A home renovation loan covers the cost of refurbishing a house. A home renovation loan can also be beneficial if you're interested in purchasing an existing house and remodeling it.

4. Owner-Builder Loan

An owner-builder loan is given to a borrower who wants to pursue the construction of their new home. Owner-builder loans are tougher to obtain. Oftentimes, creditors require owner-builders to secure a license before offering the loan.

How To Get A Construction Loan

Whether you want new construction or hope to renovate a fixer-upper, there are a few key requirements to meet to qualify:

Secure All The Documents

Your lender may require documentation of the following:

  • Identification
  • Proof of income (in the form of recent payslips and income tax returns)
  • Recent bank statements
  • A list of your assets and liabilities
  • An overview of your debts, including the loan amount, monthly payments, and interest rate
  • Your credit score

Some lenders may ask for more information.

Find A Qualified Contractor

Without a licensed general contractor, lenders are less likely to award a construction loan. The more established the contractor is (and the better their track record), the better the chances of securing that loan.

What To Look For In A Contractor?

First, hire someone with a lot of experience. The best contractors are familiar with every aspect of home building, from design to basic repairs. Next, contract someone with a good reputation. When narrowing down the list, ask previous clients about their experience, as well as check online reviews.

Last, get a contractor who listens. While you should welcome professional advice, don't let your contractor change all your plans. Just like all good relationships, you should communicate well with the contractor to achieve your goals.

Prepare The Blue Book

A "blue book" is a comprehensive document detailing the project timeline, floor plans, and even profit projections. Your blue book should also include a list of the materials and suppliers needed, as well as all the subcontractors you'll work with. In essence, the blue book "pitches" your case to lenders, assuring them that you have a feasible plan.

Get An Appraisal

An appraiser determines the value of the home prior to construction. Appraisers consider several factors when determining your future home's value, including the location, the market condition, and the proposed features.

Prepare The Down Payment

As mentioned earlier, home construction loans require higher down payments. Some financiers may even ask for up to 25 percent of the total amount. Before securing a construction loan, make sure you've done the research and estimated the value of a new construction in your selected area.

Is A Construction Loan Worth It?

Following are a few advantages and disadvantages to help you decide:

Pros

  • You only have to pay for interest: With a construction loan, you don't pay the principal until the construction is completed. This means you'll have at most one year to save up for a mortgage.
  • The added scrutiny will push you to create more detailed plans: Because creditors are strict about documentation, planning, and following through on those plans, you become more stringent. This keeps you motivated about completing things on time and staying within budget.
  • You get to plan and build a home based on your preferences: The biggest advantage of securing a construction loan is building your dream home. After all, you're in charge of the project.

Cons

  • Numerous requirements: Lenders have to make sure their money is in safe hands, so they ask for a ton of paperwork, from proof of income and employment to the details of construction plans. This can be time-consuming.
  • Higher interest: Aside from higher interest rates, you may deal with a floating or variable interest rate as well. This means the rate can change, making it difficult to project the payments.
  • Higher down payment: Lenders have nothing to secure as collateral.

Conclusion

If you have a vision for what your dream home looks like, a construction loan can turn that dream into a reality. However, achieving it comes at a cost – a long list of requirements, stricter lenders, and lofty upfront fees.

Whether you'd like to secure a C2P loan, an owner-builder loan, or a typical mortgage, Wesley Mortgage can guide you through the complicated process of financing a home.

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