Deconstructing Home Construction Loans: What You Need to Know

Sometimes, you find the diamond in the rough or a gem in your favorite neighborhood, and you need to get a standard mortgage. Other times, you find the perfect view and want to build the home of your dreams. Rather than take out a traditional mortgage, you’ll need a construction loan instead.

For those who want to start from the ground up, you’re in good company. The U.S. Census Bureau and the U.S. Department of Housing and Urban Development confirmed that over 1.1 million new home buildswere completed in December 2017. A construction loan for a new house is very similar to a traditional mortgage loan, at Cornerstone Home Lending, Inc., NMLS #208602, says. But unlike a traditional mortgage, you won’t be paying funds in one lump sum to a seller. Your funds will be paid in increments over the period of time it takes to build a home using a construction loan for funding.

Depending on the type of loan you choose, your loan may also be temporary in nature. “A construction loan is usually 6 to 18 months and covers the period of construction only. A standard, more permanent mortgage will be required upon completion,” Cummins explains.

How does a home construction loan work?

Besides the short shelf life, there are several distinctions that set a construction loan apart from other types of mortgages:

  • Slightly higher down payment. Mortgage lenders, Cummins says, deem construction loans to be a bit riskier. Cummins explains that most lenders will require a minimum of 20 percent down on the cost of construction to proceed. Compare this to other low and no-down payment home loan options like the USDA, VA, FHA, and conventional loan programs for standard purchases. FHA loans, for example, are frequently used among first-time buyers because they can be affordable with an estimated 3.5 percent minimum down payment. Construction loan interest rates may also be higher.
  • Credit score requirements. Your credit is another factor that a lender looks at to determine the riskiness of your loan. When buying a house, a higher credit score is helpful, but many lenders are willing to work with first-time homebuyers and repeat buyers who may have lower credit. In fact, mortgage lenders often expect a first-time buyer’s credit score to be lower. But to secure a construction loan for a new build, you’ll need to have your credit in good shape. Cummins says a credit score of 680 or better is typically seen as a requirement for construction loan programs.
  • Builder track record requirements. Along with a healthy credit score, construction home loan requirements will likely include choosing a reputable builder. Reputable meaning a builder with a positive track record of construction. With a construction loan, a lender is essentially working with a third-party — your builder. Anticipate a lender checking your builder’s references and reviewing any other projects they’ve done. A builder with even minor credit issues or judgments against them could pose a red flag to a lender. Further documentation to support a builder’s credentials may be requested, including proof of insurance, work history, blueprints, a signed contract, and a detailed work plan and budget.

This may sound like a lot, Cummins says, but a construction lender will only have that loan for a very short time. In that time frame, this lender runs the risk of non-completion by the builder, not to mention cost overruns and/or a borrower’s inability to qualify for permanent financing once their house is built.

Understanding the 2 construction loan types

Construction loan options abound, and choices can quickly get complicated. In broader categories, there are two basic non-commercial construction loan types:

  1. Construction-only home loan. Using this construction loan, a lender provides a set amount of money to cover the cost of a home’s construction. As the borrower, you’ll normally be expected to pay against the interest on the loan until the project is finished for a short-term, set amount of time. The principal balance of your construction loan should be due once the project wraps or up to one year later. Then you can apply for a mortgage with the lender of your choosing.
  2. Construction-to-permanent home loan. This loan will cover your home’s construction, as well as the mortgage on your home once the project is finished. This type of two-in-one loan normally only has one closing, and you’ll work with the same lender for your construction and your mortgage. The interest rate given to you for the construction project may change once you move into your home and begin making monthly mortgage payments.

After your dream home is built, you’re free to refinance the outstanding construction loan balance into any qualifying mortgage loan. Because the construction note will have a maturity date listed, Cummins explains, most refinances take place within 30 days of completion. If you’ve taken out a construction-only home loan, Cummins suggests tying up loose ends early. “Be sure to keep an eye on a builder’s progress and reach out to a permanent mortgage provider to shore up any loan items needed,” he says.

Bethany Ramos is the Creative Writer for Cornerstone Home Lending, Inc. Her work has also been featured on SheKnows.com, Time.com, Yahoo.com, Mamamia.com.au, Babble.com, and HuffingtonPost.com.

For educational purposes only. Please contact your qualified professional for specific guidance.

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