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Building a house instead of buying? What to know about construction loans

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Construction loans finance the construction of a new home. (Shutterstock)

Building a new home can provide many benefits. You can choose the layout that suits your family perfectly and with a style that makes your home look like you from day one.

But the process can be difficult, especially when it comes to funding. You’ll likely need a construction loan, which works differently than a traditional mortgage. Aligning your construction loan before you begin construction can make building your home much smoother. Let’s see how a construction loan works and how to get one.

Although you can turn to a construction loan for to build a homea personal loan can be a good option for financing other real estate projects, including renovations and additions.

What is a construction loan and how does it work?

A construction loan is a special type of financing that covers the cost of building a new residential home. It works differently from a mortgage. Construction loans are more like personal loans – they are usually short term and at higher interest rates due to the added risk for the lender. If you are unable to make your payments, a partially built home is difficult to sell after foreclosure.

Unlike personal loans or mortgages, construction loan funds are not disbursed all at once. Instead, you or your contractor will be able to withdraw from the loan in stages as construction progresses. While construction, you will generally only make interest payments on the loan. You can start making your loan payments six months to two years after loan closing, depending on your construction schedule. At the end of the construction of the house, the loan usually converts to a traditional mortgage, although you may have to pay off the construction loan in a lump sum.

Construction loan drawdown schedule

The process of disbursement of construction loan funds is known as the drawdown schedule. Before closing, you and the homebuilder will sign an agreement outlining how the draw schedule will work, usually corresponding to the different construction phases. Your builder may request to draw on the construction loan as the work is completed and inspected.

Generally, you cannot make the final draw until construction is complete and the local government issues a certificate of occupancy. A lender may charge a penalty fee if building your home takes longer than expected.

Different types of construction loans

The construction loan that is best for building your new home depends on your situation. A few variables will help determine the type of loan you choose. These can include the project you have in mind, who is doing the work, and how the overall market is changing.

Construction loan to permanent

Construction-to-permanent loans start out as a construction loan to pay construction costs, then turn into permanent financing once you’re ready to move in. You typically close the loan once and pay a set of closing costs, making it more convenient and cost effective. You can also lock in an interest rate, making it a good option if rates go up.

Construction loan only

These loans only cover the construction phase of the project. You can repay the loan in a lump sum at the end of construction, or you can take out a traditional mortgage.

If interest rates drop, you can choose this option to get a lower rate on your permanent mortgage. You can also go this route if you want to pursue a post-construction mortgage rather than sticking to a particular permanent construction loan program. However, in many cases applying for two different loans will increase your costs and risk.

Owner-builder construction loan

Many construction loans require you to work with a home builder or general contractor on your project. If you want to supervise the work yourself, you will need an owner-builder construction loan. You may find it harder to find or qualify for these loans, but if you do, you may be able to save money on overhead.

Renovation loan

If your construction project involves improving an existing house rather than building a new one, you can opt for a renovation loan. These loans allow you to buy a home and fix it up, or finance repairs or additions to a home you already own. You can also use a personal loan to finance home renovations or improvements.

What costs can I pay with a construction loan?

Typically, a home construction loan can only be used to pay for the actual costs of building the home – labor and materials, as well as permits, landscaping and repairs. other necessary items. This generally does not include furniture or other removable items. Some appliances may be covered by the construction loan, but you’ll want to make sure before you close.

What are the interest rates for construction loans?

As with any loan, interest rates on construction loans vary from day to day, from lender to lender and depending on your personal financial situation. But construction loan rates are usually higher than traditional mortgages, because you’ll usually only make interest payments on the loan during construction – for up to 18 months – before paying off in full. principal and interest once the loan is converted into a permanent mortgage. .

With permanent construction loans, you can usually lock in your interest rate for the permanent mortgage in advance. This allows you to shop around and compare interest rate offers from several lenders before choosing one.

How to get a construction loan?

You may be able to get a construction loan from a traditional lender like a bank or credit union, or from a specialty lender. Lenders may offer their own construction loan programs or work through a government program, such as an FHA construction loan, VA construction loan, or USDA construction loan. But you must meet certain criteria to qualify for a construction loan, and the requirements may be more stringent than for a standard mortgage.

Construction loan requirements

Most mortgages require a certain credit score to qualify, and requirements for construction loans are often higher. Many lenders look for a minimum credit score of 680, and sometimes as high as 720, to qualify. You will also need to document your income and assets to demonstrate that you are able to repay the loan.

Installments on construction loan

Down payment requirements on construction loans are also often higher than for other types of mortgages. You may need to deposit up to 20%-30% to qualify for a construction loan, although less deposit options may be available depending on your credit. You can often find construction loans with down payments as low as 5%. Some programs, like VA construction loans and USDA construction loans, may not require a down payment.

How to find a construction lender

Many banks, credit unions, and specialty lenders advertise their construction loans online. You should be able to fairly easily find several lenders that offer construction loans in your area. It is essential to shop around for a construction lender before settling on a loan. Prequalify with several different lenders and get a quote to compare interest rate, down payment requirements, and other loan features before you choose.

Alternatives to construction loans

Although construction loans can be a great way to finance the construction of your dream home, they are not your only option. You might want to consider these other ways to start your building project:

  • Land loan If you want to buy your land before you start construction, many lenders offer land loans to finance the purchase. You will probably need to get a construction loan or some other type of loan to actually build.
  • Home Equity Loan If you currently own a home, you may be able to leverage the home equity to build a new home. A home equity loan is disbursed as a lump sum, and a home equity line of credit allows you to draw on a maximum amount over time.
  • hard money loan Hard money loans usually offer quick approval, but come with significantly higher interest rates and short loan terms.
  • Personal loan Personal loans are generally unsecured and come with higher interest rates, but they can be used for virtually any purpose.
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