Construction Loan 101 Guide: How Does It Works?

Buying a home is a big decision, but when you are trying to build your own house, the stakes become even higher.

It is a challenging (and often stressful) task to put things together – the right contractor for your home, the best suppliers, working your monthly mortgage payments into the family budget, etc.

This is where a construction loan can help.  It is a sum of money that you receive to help finance your building costs and helps you succeed in this huge financial undertaking.

Whether you’re building a house from the ground up or renovating an existing structure, construction loans are helpful because they have certain features that you won’t find in traditional mortgages.

But before you sign the contract, arm yourself with the basics of construction loans and how they apply in the real world.

What is a Construction Loan?

A construction loan is a short-term, interim loan that provides a borrower the money to fund the cost of building or renovating a home.

Generally, construction loan lenders charge higher interest rates than longer-term mortgages some borrowers take to purchase their homes.

  With a construction loan, the lender will release the fund through a series of advances depending on how the construction progresses.  The borrower begins payment for the loan around six to twelve months after he gets the loan.

They call these installments as “draws”.  Every draw is a reimbursement to the builder for the costs needed to cover a certain phase of the building process.

This means that the borrower must have enough cash on hand upfront to advance the costs.

Before the borrower can make a draw, the bank will have to inspect and verify the estimated cost of the current phase of the project.  They will also check if the builder is meeting the timeline for the project.

Types of Construction Loans

There are three major types of construction loans that are available to borrowers.  They are:

Construction-to-Permanent Loan

This is most ideal for a builder who has a definite construction plan and timelines in place.

In this type of loan, the bank will pay the builder as the work is in progress.  Afterward, the bank converts the cost to a mortgage at closing.

The nice thing about it is that you can lock your closing interest rate so you can have fixed, steady payments later.

Construction-Only Loan

A borrower must pay off this loan in full as soon as he finishes building.

This is great for builders who have a large amount of cash at their disposal or for those who are confident that the proceeds from the sale of their current home will be enough to cover another project.

In this type of loan, if the borrower needs a mortgage to cover the cost, he himself will have to search for the lender and go through the approval process a second time.

Renovation Construction Loan

With this type of loan from a trusted lender, borrowers may lump the costs of the whole construction and renovation into the final mortgage.

The estimated value of the house after repairs and renovations will dictate how big the loan will be.  This loan is most suitable for individuals who are in search of a house in need of major repairs.

Realtor often calls these properties as “fixer-uppers.”

Who Can Qualify For a Construction Loan?

If it were up to them, bankers and mortgage lenders would rather not have anything to do with construction loans for many reasons.  One of the major issues is that the borrower should be exceedingly trustworthy.

The bank or lender will actually be betting on the future, specifically that the borrower will complete the construction and the property will command a sufficient market price at its finished state.

Just like buying a house, the best thing to do is to get pre-qualified for a home construction loan before you even think of looking for furniture.

Here’s a warning though:  it’s not going to be easy to qualify with lenders.

Lenders will first of all look at your credit history and debt-to-income ratio.  Then, they may look at other factors that may affect your creditworthiness.

For example, TD Bank will require you to provide a signed contract with your builder that shows the budget and timeline of your building project.

But that could be putting the cart ahead of the horse.  Before proceeding, you need to take a serious look at your finances. You can start by asking yourself how much of a house you can afford.

After that, you’ll have to put in all the extra costs of borrowing to finish it.

Construction Loan Requirements

The bank knows that a lot of things can go wrong in this set-up.  For example, the builder may do a sloppy job or overall property values can suddenly drop.

The bank will then realize they made a wrong decision to give out the loan.  The property value won’t be enough to cover the cost of the loan.

To mitigate their risks, banks would often impose strict requirements for a construction loan.  These usually include the following:

There Should Be A Qualified Builder In The Picture

A qualified builder is usually a licensed general contractor with a track record of building quality homes.

So, if you’re thinking D-I-Y by acting as your own general contractor or assuming an owner/builder role in the project, you may have a hard time finding a lender.

You Must Provide The Lender With Detailed Specifications

Lenders will often ask for the specs of the project which include the floor plans, list of materials, blueprints, etc.

Builders usually prepare all these things before starting the project (they call it the “blue book”) and will contain everything from ceiling heights to the number of electrical outlets to the type of insulation they will install.

Have An Appraiser Estimate The Home Value

It may seem like an impossible idea to estimate the value of something that doesn’t exist now but the lender must get a professional appraiser to peg down the value of the finished project.

The appraiser will base it on the blue book, specs of the project, the value of the land where the lender will build it on, and other relevant factors.

They would often compare these calculations to the prevailing values of the other properties in the neighborhood that are in a similar location, with similar features and size.

They call these other houses as ‘comps’ and an appraiser will give his valuation based on the comps.

You Must Pay A Large Down Payment

Generally, 20% of the loan is the minimum down payment for a construction loan but some lenders may ask for 25 percent.  This is to assure them that you have both feet into the project and won’t just hop on the bus if things go wrong.

This is also protection for the bank or the lender in case the home’s value doesn’t reach the amount that they were expecting.

Granting that you have good credit and have complied with all these criteria, you should have no trouble qualifying for a construction loan.

Lenders will definitely ask for information about your regular income so they can be sure that you can afford the mortgage.  And of course, they would also check your current home – the same way they would do if it were a regular mortgage loan.

Construction Loan Pros, Cons & Tips For Borrowers

A construction loan can be a great option in different circumstances, but on the other hand disastrous if you aren’t gully awared of its optional consequences.

Here are the most important pros and cons, as well as a couple of tips for relevant borrowers:

Benefits of a Construction Loan

Opting for a construction loan in favor of a home equity line of credit or other private loan has its distinct benefits.  These are:

Flexible terms.  In terms of flexibility, construction loan terms and guidelines are better compared to traditional loans.

You pay only the interest during construction.  You only pay the loan in full when the new construction is complete so this means that the lender won’t pester you with principal payments before that period.  Other loans will require you to pay part of the principal every month so your monthly costs become bigger.

You can choose a construction to permanent loan.   You can get the money you need for building the project and the extra time you might need to pay it back.  After you’ve finished the construction, the construction loan transitions to a mortgage-like loan.

You benefit from the added scrutiny.   Remember that the bank will ask for detailed plans and timelines of the project.  This works in your favor because your contractors will now have to give you clear and straightforward answers regarding the project and will not leave you with vague answers.

You have a lot of freedom over how you want your home done.  When you have control of the funds and employing a builder, you have the freedom to direct how you want your future house to look like.  In essence, you are now at full liberty to build your dream home.

Disadvantages of a Construction Loan

Of course, there are also disadvantages to a construction loan.  These are:

 It’s not easy to qualify for them.  Think of a credit score of not less than 650 and the ability to pay a down payment of 20%.

You will have to pay higher monthly mortgage payments.  Since during the construction period, you will only pay interest, when the time comes for you to pay the permanent loan, you should expect your monthly payments to increase.

Your funds will come in stages. Forget about having everything at your disposal.  The lender will release the funds in proportion to the progress of your construction.

You will pay higher interest rates.  Lenders package construction loan interest in such a way that aside from it being variable, they add a certain percentage over the prime rate or the rate that banks give their best borrowers.

Shorter-term loans give you more risk.  Remember that at the end of the loan term, the lender will demand payment for the full loan.  Since this is a short-term loan, you will have a shorter period to build up your repayment funds for your loan.

What About a Standard Home Loan Instead?

It could work.  But only if you have enough equity in an existing standard home loan so that you can borrow a sufficient amount to fund your project without having to pledge your future home as collateral.

If you have built up enough equity on the parcel of land itself or in other assets such as investment properties, you may be able to redraw the funds for your construction loan.

It will be up to you if you want to take a lump sum or draw them progressively.

The big plus of redrawing from an existing loan is that it enables you to pay the construction costs as they come in and gives you enough money to pay for incidental costs that you will encounter from time to time.

A potential financial disadvantage is that in a case when you fully draw the loan on Day 1, your interest begins to run on the same day.

You can ease the impact by placing any unspent money in a 100% offset account against the loan.

Since construction loan rates are higher at the beginning, you can try to refinance it into a permanent mortgage once you are done with the construction.

If you canvass for rates, you might be able to get a lower rate for your loan.

 Construction Loan Tips For Borrowers

Look for an experienced loan officer

As you look for a lender, you should find a seasoned loan officer who has a lot of experience with construction loans. They’re the ones who will explain the process.

They need to be a good communicator and have done a lot of this kind of lending.

If the loan officer has only done a couple of these, it will be bumpy.  It doesn’t matter if you use a mortgage broker or a banker, as long as he or she has the experience.

Set some money aside

Building the house of your dreams can be an exhilarating experience but you should be careful to avoid turning it into a financial nightmare.

Plan ahead financially before you start building by setting up a savings account.  This account is where you can set aside funds in case unexpected needs arise (because they normally happen in projects like this).

For example, you start digging and discover that there are rock shelves under your property.  The old adage is still relevant:  better safe than sorry.

Take note of the advance schedule

Always be on the alert and inform your builder of the schedule then get his express agreement.

Builders are also businessmen who rely on capital so some of them are more liquid than others.  Other builders won’t be able to operate as flexible as others can and would need the funds on a stricter schedule.

The bank will stick to the schedule so they will not release the funds too early.