Construction Loans- 2021CASAPLORERTrusted and Transparent
What is a construction loan?
A construction loan or a home construction loan is a short-term loan to fund the costs of building a house. Home construction loans have a duration of about 12 months and have high-interest rates as there is no collateral backing the loan. Once the home is built, the loan is either paid in full or refinanced into a long-term mortgage. The contractor is paid directly by the lender in installments as the project progresses. The loan can be used to pay for a variety of costs such as permits, labor, materials, and supplies. Construction loans are perfect for individuals who want to have a house that matches all their specifications but do not have the funds to build the home.
How do construction loans work?
Home construction loans are structured differently than traditional loans. For this loan, you will be required to make a meticulous plan that shows every step of the construction process, detailed plans, and the estimated costs. The lender will also require approving the builder who will get the funds for the construction.
Unlike a traditional loan where you receive a lump-sum payment at the onset of the loan, the lender pays the contractor directly in phases, known as ‘draws’. This helps mitigate the risk for the lender and allows them to track the home building process. The contractor receives funds for every draw which is linked to an important phase of the home construction process, such as building the foundation, home framework, roofing, and finishing. Each time funds are to be disbursed, an inspection is required by an agent to track the process and determine the amount of funds needed.
When the home is being built, you will in most cases only be able to make interest-only payments. Each time there is a draw, the outstanding balance will increase, resulting in larger interest payments as the home moves towards completion. Once the home is ready for you, the construction loan can be paid back in full along with any interest payments, or if you are planning to take a mortgage, you can include the outstanding balance in your long-term mortgage.
What are construction loan interest rates?
Construction Loans Interest Rate
Construction loans are charged using a variable-rate which means they can change in an unpredictable manner. Variable rates follow a benchmark index like the prime rate which is connected to the Fed funds rate. Construction loan interest rates will be the prime rate plus an additional credit spread determined by the lender. As the prime rate rises, the variable rate for your construction loan will also rise, which will result in larger interest payments. Home construction loans tend to have higher interest rates than mortgages because the lender does not have collateral that can be collected if you default on your payments. Hence, lenders view construction loans as much riskier than mortgages.
Types of construction loans
There are 3 different types of construction loans with their own benefits and requirements.
|Construction-to-Permanent Loan||Construction Only Loan||Renovation Loan|
|Repayment||Converts to a mortgage||Paid back in full||Installments|
|Interest Rate||Locked at closing||Flexible||Flexible|
In this type of home construction loan, the loan provides funds to cover the construction costs and the mortgage. As previously discussed, once the construction is over you can pay back the loan or refinance it into a mortgage. In a construction-to-permanent, you borrow funds to build the home and once the home is completed, the loan is converted into a mortgage.
The biggest advantage of this loan is that you have to pay closing costs only once, as the construction loan will eventually become the mortgage. As the loan converts to a mortgage, you do not need to be worried about the future hassle of getting a mortgage and going through the application process again. You should use this type of home construction loan when you are extremely clear in your plans of building a home and want predictable interest rates.
The disadvantage is that you are locked into a mortgage rate with certain terms almost a year before your mortgage actually starts. Should mortgage rates drastically fall in that period, you cannot benefit from the decline in rates.
In this type of loan, you only borrow money to finance the cost of building the house. Once the home is completed, the loan is paid back in full and a separate mortgage is required for the home. The funds are transferred directly to the contractor in ‘draws’ and you will be required to make interest-only payments on the loan. The interest rate charged on construction-only loans is linked to theprime rate and an additional margin.
The biggest advantage of this loan is that it gives you flexibility and time to find the best mortgage lender for your needs. You can try to get a lower mortgage rate with terms if you have ample time to do research and negotiate. In a construction-to-permanent loan, you have to stick to the mortgage rate and terms given by the lender who is willing to accept both construction and a mortgage.
As there are two different loan processes, there are multiple costs between the two which can raise the overall costs of construction and the mortgage. Apart from costs, time will also have to be spent on paperwork for both loans. Therefore, the time and cost factor for this type of loan is significantly larger than the construction-to-permanent loan. Another disadvantage is that you have no mortgage already lined up when it is time to convert. If you happen to lose your job, your income falls or your credit score worsens, at the time of the mortgage application you can get rejected and this can prevent you from moving into the new house.
This loan is for homes that are already built but requires renovations and upgrades. There are several renovation or home improvement loans that differ in terms of the loan amount, requirements, flexibility, and repayments.
If you have smaller projects for less than $20,000 then personal loans can be a great option. No collateral is required, and the application and vetting process is relatively fast. You can receive the funds within days of the application and repayment stretches for 2 – 5 years. As there is no collateral backing the loan, interest rate charges are higher than other alternatives. If you have an emergency and need funds instantly, then a credit card will be the best option.
If you have lived in the home for a couple of years and have built up home equity, then you can consider getting a home equity line of credit (HELOC) or a home equity loan. Both allow you to borrow funds based on the amount of equity you own in the home. Both have lower interest rates and can extend for up to 20 years giving you ample time to plan and repay the loans. These loans are perfect for large well-planned projects such as redesigning the entire basement or building a pool.
Lastly, due to the low-interest rate environment, another option for home renovations is a cash-out refinance. In a cash-out refinance you borrow funds that are greater than what you require to pay back your existing mortgage. These additional funds can be used for home remodeling or renovations. The advantage is that you do not have to make separate payments as the loan is part of the mortgage. You can calculate the total amount you are eligible for using our cash-out refinance calculator.
To learn more about these different programs visit our home improvement loans page.
What is an owner-builder construction loan?
Owner builder construction loans are different from the other types of loans because in this loan you will be the contractor for the project. Instead of hiring and managing an external contractor, you will be planning, building, and executing the project without external help. This option can save you money as you will not have to pay the contractor fees, however, lenders will only accept this form of the loan if you are a licensed contractor by trade who has experience with construction and building regulations.
What is an end loan?
End loan is another term for a mortgage loan once the home construction is complete. When the home is being built it is known as a construction loan, and when the home is complete the borrower will have to pay their mortgage which is the end loan.
How do I get a construction loan?
The process of getting a home construction loan is very similar to a mortgage. The steps are as follows:
- Lender search: Initially you should do research on the different lenders that offer construction loans and the different varieties. You should choose the lender that best satisfies your financial needs, be it a low-interest rate or repayment terms.
- Pre-approval: Once the lender is determined, you can get pre-approved where the lender will check your basic financials such as credit score and income.
- Scouting: Once you have an estimated borrowing amount from the lender, you can start searching for the right type of property and the size of the land.
- Planning: This is a crucial step where you will be required to plan how the construction work will be done, the timeline, and create a full budget with all costs. This is submitted to the lender too.
- Approval: The lender will do a deep dive into your financials which will include income, tax returns, debt, credit score, and savings. Once the loan is approved, construction can begin and the funds will be sent to the contractor directly in phases.
What are the eligibility requirements to get a construction loan?
The requirements to get a construction loan varies from lender to lender but the general criteria is as follows:
- Credit Score: Lenders will require a credit score greater than 680. The reason for the higher credit score is because of the added risk to the lender as a result of the lack of collateral backing the loan.
- Debt-to-Income (DTI) Ratio: The DTI ratio should not be greater than 45%. What this means is less than 45% of your gross monthly income should be going towards monthly debt repayments. For example, if you are earning $8,000 in a month, no more than $3,600 should be going towards debt repayments.
- Minimum Down Payment: The minimum down payment required is 20%, which results in a maximum loan-to-value (LTV) ratio of 80%.
- Repayment Plan: The lender will require a proper repayment plan depending on the loan option selected. If you decide to take a construction-only loan, the lender will need to know whether you will pay the outstanding balance at the end of the construction or refinance the loan into a mortgage. Financials such as income, savings, debt, and other factors will also be analyzed to determine if you will be able to repay the loan.
Should I get a construction loan?
There are a couple of factors to consider before getting a home construction loan:
- Time Constraint: Time is an important factor, if you have to vacate your existing home quickly and move into the new house, construction loans might not be the best option for you. The reason being construction can get delayed, plans get changed, and there has to be room for unforeseen events.
- Application Process: You should research and be clear if construction loans are correct for your needs and which loan type to take. Do you want to go through the application process twice? Do you already have a mortgage lender ready? These kinds of questions can help you determine which construction loan to take.
- Land Purchase: Do you already have the land ready for the construction to begin or do you need time to search? It is important to consider the additional costs of purchasing land, construction costs, and eventually your mortgage costs.
- Home Specifications: If you want very specific aspects to your home rather than what already exists in the market or what can be done through remodeling, then a home construction loan could be the right loan.
Can the construction loan be used for furnishing and design?
No, the construction loan cannot be used for furnishings or design as the funds go directly to the contractor for the building. All other aspects such as buying furniture and re-design will be an out of pocket expense. If there are funds leftover in the loan, such that the construction costs come under budget, then the funds do not come to you. Instead, you have to pay back a smaller amount at the end of the loan.