Construction loans are the most common way to finance a custom home build. Anyone who requires financing for their home build will likely be using a construction loan so it’s important to understand what they are exactly, how they work, and the differences between a construction loan and a conventional mortgage. Here we’ll cover these topics and review types of construction loans and answer some of the most common questions people have about construction loans.
What is a construction loan?
A construction loan is a specific loan type used to finance the construction of a new home during the construction phase of a home building project. Construction loans are used for financing the land, contractor labor and builder fees, building materials, and the cost of building permits. The most common type of construction loan is a construction to permanent loan, which is used to finance the construction of the home and then automatically converts to a conventional mortgage when construction is complete.
Because the construction phase is typically a short period of time, the construction loan portion of a construction to permanent loan is a short-term loan. A common loan length is one year, but the length of the loan will be determined based on the specifics of your project. Once construction is complete the loan amount is due and this is when the conventional mortgage is used to pay the construction loan amount.
Construction Loan Requirements
To secure a construction loan, you’ll still need to provide information on your financial status and ability to pay your loan just as you would for a conventional mortgage; however, with construction loans your lender will require detailed information about your project. This includes a build timeline or schedule, the estimated project cost, detailed plans from your home builder. Your lender may also ask for verification from your builder to prove their qualifications.
This information is used by your lender to determine the loan length and terms. It will also be used by your lender’s appraiser to determine the expected value of your completed home. The expected value of your home will factor into your loan-to-value ratio, which will also impact your construction loan amount and terms.
In addition, most construction loan lenders will require that you have homeowners insurance to cover your project, even though you aren’t living there and the home is not complete. This will cover anything that might happen during construction and help lenders to limit their risk should something happen during construction.
Most construction loans also require a minimum 20% down payment. If you already own the land you are building on, the value of the land or the amount you’ve paid for it can usually be used as the 20% payment or towards this payment.
Construction Loan Example
Here’s an example to illustrate how the land value could be used toward the construction loan down payment:
You own your land outright and the land’s value is $180,000. The cost to build your custom home is $370,000. So the total acquisition cost of the home and land is $550,000. A lender will typically only lend up to 80% of this acquisition cost. The other 20% is the amount you are responsible for as your down payment. In this scenario with the value of the land you own factored in, your construction loan amount would be $440,000, which is more than enough to cover the cost of your home construction and the land value covers the full 20% minimum down payment required.
Keep in mind this is one example meant to illustrate how a construction loan may be calculated. Each lender will have their own method of calculation which may use other values and factors for loan amount calculation. Talking with lenders about your situation is the best way to determine how your loan would be calculated and get real construction loan amounts and terms.
One other requirement to consider with construction loans is that lenders typically require a credit score of 680. There are certain types of construction loans that may have a lower credit score requirement; however, in general, 680 is common. This is higher than a conventional mortgage loan, which usually requires a credit score of 620, so it’s worth noting.
How Do Construction Loans Work?
Construction loans do not work the same way a personal loan or a mortgage does. They have a different payout schedule and payment schedule.
Construction Loan Payouts
Let’s start with the payout schedule. Once you’ve secured your construction loan, the loan funds will not be paid out all at once. Construction loan funds will be distributed at different times during the construction of your new home. Exactly when these disbursements, also called draws, are paid out is dependent on your specific lender. One common scenario is a set schedule of disbursements, which might be once a month. Another common scenario is that a disbursement occurs at certain phases of your build. For example once your foundation is in place or when you are ready to start framing.
Most disbursements will be subject to an inspector verification. This means the lender will send an inspector to your project to make sure that the project is at the actual phase it should be before you receive your disbursements.
The reason for these inspections is because lenders want to mitigate their risk. They are funding the loan based on an incomplete project and the collateral for the loan is an unbuilt home. If the project isn’t progressing as it should, a lender won’t want to continue funding the payments. This is one reason why it’s important to work with a reputable custom home builder that can deliver on the timelines and build plans that have been submitted to your lender.
In some cases the lender will be sending these disbursements directly to the builder, so you don’t need to worry about receiving and distributing funds yourself. In other cases the funds will go through you and you’ll be responsible for sending your builder the payments.
Construction Loan Payments
One of the other main things to note about how a construction loan works is that payments are only made on the interest of the loan during construction. In addition you’ll only be making these interest payments on the actual amount drawn, not on the full loan amount. This payment schedule also means that you’ll be paying less in the beginning of construction and this amount will gradually increase as more of the loan funds are drawn.
This is different from a conventional mortgage in which you’ll immediately begin making payments on the interest and principal once the loan is secured.
Interest Rates For Construction Loans
Construction loans also have variable interest rates, which are tied to the prime rate. So in addition to your payment amount changing based on the loan amount you’ve drawn, you should also expect your loan payments to include variation in the interest rate being applied.
Once construction is complete, you’ll be required to pay the principal on the loan. This is where many homeowners use a traditional mortgage to pay this balance on their construction loan once their home is built.
Types of Construction Loans
There are two main types of construction loans. The first is a standard construction loan, which will cover only construction. The second is called a construction to permanent loan. This loan covers the construction and is automatically converted into a conventional mortgage, following the construction phase.
Construction to Permanent Loan
This type of construction loan is also referred to as a one-time close construction loan, a single-close construction loan, or an all in one construction loan. This loan type allows you to get a single loan that will cover both your construction and is then converted to a standard mortgage upon completion. Once converted to a mortgage this loan has the same options as other mortgage loans such as a variable rate or a fixed rate and different term amounts like 15 or 30 years.
During construction, you’ll pay just the interest amount as you would with a standard construction loan and once the loan is converted, you’ll make payments on your mortgage that include interest and principal, just as you would with any conventional mortgage.
The benefit of the construction to permanent loan is that it’s less work for you because you don’t need to worry about getting a mortgage to cover the construction loan once home construction is complete. There is no need to go through a second approval process, no need to fill out additional paperwork, and even better, you’ll save money without paying closing costs on a separate mortgage. You’ll pay closing costs just once.
There are some variations to this depending on your lender, where some may charge another fee when your construction loan moves to an end loan (another name for the mortgage loan when construction is complete). So be sure to confirm this with your lender when you are shopping for your loan.
Another potential benefit is that if anything changes with your financial situation during the build, you’ve already secured your mortgage, so you don’t need to worry about trouble applying for a mortgage when construction is nearing completion. At the same time, if any changes to mortgage rates or the market occur, you’ve already locked in your funding and rate. If interest rates decrease, this can work against you, so it’s here as a potential benefit.
There are a few subtypes of construction to permanent loans, an FHA construction to permanent loan and a VA construction to permanent loan. These loans have special requirements for those who meet the qualifications.
Construction Only Loan
The construction only loan is the standard construction loan. As the name suggests it covers just the construction phase. With this loan type you are responsible for paying the interest payments during construction of your home and then you’ll be responsible for paying the principal loan amount upon construction completion at the end of the loan term.
To finance the final payment of the construction loan, most people will secure a mortgage. This means that you’ll have to go through the loan application process twice, once for your construction only loan and again to secure your separate mortgage loan. You’ll also need to pay closing costs for both loans.
The potential benefit to using a construction only loan is that if interest rates go down during home construction, you may be able to secure a lower rate for your mortgage than you would if you had a construction to permanent loan. This can also work against you, if the rates were to go up during construction.
Owner Builder Construction Loan
This construction loan is for someone who will be acting as their own builder. It really isn’t that common as most lenders won’t loan unless you are a licensed trade professional. Building a house is a complicated project, so lenders want to ensure that you know what you are doing if you are attempting to build your own home. This owner-builder construction loan can be set up as construction only or construction to permanent.
Differences Between Construction Loans & Conventional Mortgages
There are several key differences between construction loans and conventional mortgages. A few of the biggest differences are the repayment timeline and payment schedules. A construction loan is created as a short term loan so the repayment timeline is much shorter than a conventional mortgage. A construction loan is typically 12 months, but this can vary based on the individual project.
Payments
In addition, payments for a construction loan will only be on the interest of the loan at first. These interest payments are based on the amount of the loan that has been drawn, so they will change as the project progresses towards completion. The interest rate is also variable, which contributes to the varying payment amounts due on a construction loan. With a construction loan, the principal amount is due when the loan term ends. This is all versus a standard mortgage where payments are the same over the loan term and you will immediately start paying both the interest and the principal with your mortgage payments.
Interest Rates
Construction loans typically have a 1% higher interest rate than a standard mortgage. This is because the loan does not have a finished house as collateral, which makes them riskier for lenders.
Payment Schedules
Another key difference between construction loans and a mortgage is the payout schedule. When you secure a mortgage the full lump sum of the loan is paid out right away. As we covered earlier, a construction loan is paid out over the construction based on set intervals or phases of project completion. The full loan amount is not paid out all at once.
The construction loan payouts are also subject to inspections or appraisals that confirm your home construction has reached the next phase to secure the next payout. This differs from the single, initial appraisal that takes place when you secure a conventional mortgage loan.
Construction Loan FAQs
Does every bank offer construction loans?
It is common for banks to offer construction loans for residential properties; however, not all loans or loan processes are the same. As we recommend when choosing a home builder, we also recommend shopping around and talking with different lenders in Boise to find one that fits your needs.
Is it harder to get a construction loan?
It can be more difficult to secure a construction loan for two reasons. One, the average credit score required for a construction loan is higher than that of a conventional mortgage. For a construction loan most lenders require a credit score of 680 versus a conventional mortgage where the requirement is usually 620. Although there are exceptions to this with VA or FHA construction loans.
The second reason it may be more difficult to secure a construction loan is that most require a minimum 20% down payment. However in some cases if you already own the land, the land can be used as your 20% down payment or a portion of it.
What if the project takes longer than the timeline?
Some construction loans have the built in option to extend the loan term in order to account for this scenario. If construction is taking longer than expected, be sure to communicate with your lender about the project status in order to work with them to find a solution to a delay in construction that pushes out your timeline.
Do construction loans cover home design?
No, construction loans do not cover the cost of home design. Most custom home builders have a set design fee that you will pay for the design of your custom home. This fee can vary, but at Pathway Builders our design fee is $5,000. Once you have your designs, you’ll be able to gather the details like build plan, project cost, and timeline needed to secure your construction loan.
What happens if I already have a land loan?
Most often construction loans will pay this amount off. This means you’ll have just one payment instead of two, because your construction loan lender becomes the sole lender. The amount you’ve already paid to your land loan is factored into the 20% down payment required to secure your construction loan.
If you have more questions about construction loans to finance your custom home build, you can contact us. Our team of home-building experts is here to help. If we aren’t able to answer your question, we are happy to refer you to someone who can.