Finding the right home is no easy task. Whether you plan to occupy the property or rent it out, it can certainly be convenient to buy a home that is already built; however, it is not always the best choice. You may have specific expectations of how everything should look, but none of the available properties come close to your vision. Or you may be dreaming about designing your residential property from its finest details to its final form, which can only be achieved through construction or renovations.
Home construction loans cater to borrowers who want to customize the perfect property for their home or investment
If you are caught in these dilemmas, you might be worried about the cost of building a new home or renovating an existing one. The solution is to get a construction loan. You should be aware, however, that home construction loans differ from other residential mortgages. They can be a bit more complicated and come with additional requirements.
In this article, you will find everything you need to know about residential construction loans and how you can qualify for one. To compare it to other residential loans, you can read about these unconventional mortgage loans for all types of borrowers.
A construction loan is a short-term residential loan that provides borrowers with the funds needed for the construction or renovation of their homes. Funds are typically drawn in stages as the project progresses. The loan usually lasts for a year, during which you are expected to complete the project and receive the certificate of occupancy.
This type of loan carries more risk than other residential mortgages because the real estate being financed is not yet existing in the first place. To make up for this risk, construction mortgages can come with a higher interest rate. As such, borrowers typically refinance their initial loans with a long-term permanent residential mortgage once the property is built.
If you are planning to get a residential construction loan, you may use the proceeds to build or renovate a single-family residence, townhouse, or 2-4 unit property (duplex, triplex, or quadruplex) or to renovate a condominium unit.
Properties with 5 units or more fall under the multifamily property category and are financed through commercial loans. If you wish to build or renovate one, you will need a commercial construction loan instead. As a start, here’s everything to know about commercial construction loans.
Depending on the lender, there may be limitations on the acceptable occupancy types. Some lenders may limit their loans to only owner-occupied or only investment properties. While others, especially the creative lenders, are more flexible with their requirements and thus, can accept both occupancy types. This article will focus on these creative construction loan programs.
But first, let us define what is considered owner-occupied and investment properties.
As its name implies, it refers to real estate meant to be used by the owner as a primary residence or second home. For instance, borrowers who are looking to build a home for their family or a vacation house in a picturesque or serene location away from home typically avail of owner-occupied construction loans.
Residential properties which you plan to rent out or sell to third parties fall under the investment category. Unlike owner-occupied, these properties are built with the goal of generating income.
The construction loan that suits your needs also depends on your experience as a real estate investor. But regardless of whether you are a first-time builder or a seasoned investor, there surely are creative construction loans available for you.
A detailed construction plan, timeline, and budget must be submitted as part of your application.
The interest rates for construction mortgages are generally higher than that of other residential loans. This is because, unlike other mortgages, this type of loan finances properties that are not yet existing.
For example, if you default on your conventional mortgage payments, the lender can take possession of your property — that is already built — through foreclosure. However, for construction loans, lenders may only be foreclosing on vacant land or a half-finished structure, so lenders see this as a higher risk situation.
Construction loans can also come with variable interest rates, which fluctuate based on the prime rate.
One characteristic of home construction loans is their short timeline. For example, some lenders may allow construction duration lasting from 9 months to 12 months, with extensions being given if necessary.
The duration of the loan is dependent on the proposed timetable for the construction. Thus, for lenders to properly assess the loan application, borrowers must submit a reasonable construction timeline, a detailed plan, and realistic budgetary requirements.
Once the application is approved, a draw schedule will be given by the lender to the borrower. This draw schedule should contain a detailed payment plan for the project, with information on when the funds will be disbursed to the contractor or builder and what requirements should be met before each draw is released. This ensures that the project progresses as planned and the funds are used for the sole purpose of the construction.
For example, a draw may be given after laying the foundation of the house. This means that unless this milestone is completed, the lender will not disburse the funds allocated for the next phase of the project.
Similarly, to ensure that satisfactory progress is being made, a third-party inspector will visit the construction site during different phases of the project. Altogether, you may generally expect around five to seven inspections until completion.
Draws are also important in determining your monthly dues because these loans are typically structured with interest-only payments. That means that while the construction is ongoing, you would only need to pay the interest for the funds drawn to date.
Borrowers may apply for a construction-to-permanent loan wherein the loan is automatically converted to a permanent, long-term mortgage once the construction is completed and is ready to be occupied.
Alternatively, the other option is to get one loan to finance the construction project and, afterward, a second loan in the form of a more permanent mortgage. This repayment option requires two loan applications and approvals.
We discuss these two options in further detail below.
Aside from the construction itself, the proceeds of the loan can also cover the cost of the land where the property is to be built, the labor costs and materials, and even other soft costs such as architectural, engineering, and permit fees.
Typically, a construction loan does not cover home furnishings, but permanent fixtures and landscaping may be included. Likewise, some home construction loans provide a contingency reserve that acts as a cushion in case the borrower decides to upgrade or change some of the details in the initial plan.
The contingency requirement varies from lender to lender. As one example, a lender may require 5 to 10% contingency funds for its construction mortgages. This is computed based on the total costs of the project, excluding the value of the land. To waive this contingency, the borrower must document additional reserves (typically around 10% more) after the down payment has been made to ensure that the project will not run over budget.
Also called the one-time close, single-close, or all-in-one close, this type of loan automatically converts your construction loan to a long-term mortgage after the project completion. It suits borrowers who cannot or prefer not to pay the balloon payment at the maturity date or those who think they may become less creditworthy in the near future.
Construction-to-permanent loans come with several advantages in the form of:
Alternative lenders have construction-to-permanent loan programs designed for borrowers who want to maximize these advantages. You may also be eligible for construction loans offered by FHA and VA.
This type of loan is also known as two-close or two-time-close because, unlike construction-to-permanent loans, it requires borrowers to re-apply and re-qualify for a permanent mortgage or end loan once the construction is completed.
With a construction-only loan, borrowers face additional risks because they shoulder the responsibility of settling the balloon payment at maturity. Borrowers may also face challenges securing a second loan, especially if their financial situation worsened from the start of construction until the completion. They need to pay two sets of closing costs which amount to thousands of dollars and depending on the market conditions, they may even end up with higher interest rates for their permanent residential mortgage loan.
Despite these disadvantages, a construction-only loan is preferable for borrowers who expect to receive a huge sum of money within the next year, or have their cash flow, credit score, and DTI improving soon. They can afford to settle the balloon payment with less risk or may qualify for a permanent mortgage with better loan terms.
A renovation loan is a special type of home construction loan because it typically does not require the borrower to build the property from the ground up. Instead, borrowers upgrade their existing dwellings, improve their rental properties, or renovate a fixer-upper, be it for flipping or rental purposes. Renovation loans are very popular in areas with older housing stock and where vacant land is unavailable.
These loans tend to be more flexible than other construction loans. This loan type can be used for a variety of purposes, some of which include:
For all of these options, borrowers may either hire a general contractor or act as their own contractor if they are doing the renovation on their own.
Each lender has their own terms for their renovation loans. As just one example, you may qualify for:
This is either a construction-to-permanent loan or a construction-only loan as described above. However, there is one twist, and that is the borrowers themselves are the builders.
Lenders offering owner-builder construction loans allow the borrowers themselves to act as their builders only if they have the trade license to do so.
In a way, the end loan can be viewed as a regular mortgage loan because it is taken with the already-built house as the collateral. It is the second part of the construction-only loan; thus, borrowers availing end loans need to undergo another closing.
End loans are especially useful because not all lenders offer a construction-to-permanent loan. However, like other conventional mortgage loans, the requirements may be stringent, especially for borrowers who have a low credit score or high debt-to-income ratio (DTI).
If you belong to this group, you should consider these unconventional mortgage loans for all types of borrowers. Regardless of your specific situation, there are creative loan programs designed to address those challenges and have flexible requirements.
There are no one-size-fits-all loan terms because your loan offer would ultimately depend on your creditworthiness, the details of your proposed construction project, and the risks involved.
But to give you an idea of what to expect, here are some general loan parameters and requirements:
The loan amounts offered under construction loans depend on your construction or renovation plans. In general, borrowers may obtain up to a $5M or more loan to finance the construction or renovation of their homes or investment properties. The minimum loan amount is usually set at $500,000, but exceptions may be given on a case-by-case basis.
When considering the loan amount, the construction lender will take into account two important ratios: (1) the loan-to-value ratio (LTV); and (2) the loan-to-cost ratio (LTC).
The LTV is calculated by dividing the loan amount by the expected market value of the completed house. The LTC is calculated by dividing the loan amount by the construction cost.
Typically, lenders allow up to 70 to 75% for LTV and 85 to 90% for LTC.
As with any loan, you need to prepare for a down payment and settle it on the closing day. Your down payment will depend on several factors, including the lender itself, the program you are applying for, your qualifications, and the loan amount.
Compared to other residential loans, home construction loans typically require a higher down payment to make up for the risks that come with this type of mortgage. For example, some programs may require up to a 30% down payment.
Lenders need your credit score to evaluate your creditworthiness. Because of the inherent risks associated with construction loans, most construction lenders require a good credit score around the 700s. This provides lenders extra assurance given the final property to be financed is not yet in existence.
DTI is your monthly payables divided by your monthly gross income. Lenders use this parameter to gauge how likely you’ll be able to manage your monthly repayments if you are given a home construction loan.
Borrowers with low DTI are considered less risky by banks because they have fewer debts relative to their monthly income; thus, they can accommodate additional mortgage dues. In contrast, a high DTI suggests that the borrower may have too much on their plates and have limited income remaining after paying all of their existing debts. The DTI requirement varies from lender to lender, and it’s best to ask your lender so you can consider other options if needed.
Some lenders, especially the traditional ones, limit their construction loans to U.S. citizens. If you are a foreign national or other non-U.S. citizens who wish to finance the construction of your residential property in the U.S., you may want to consider alternative lenders instead. Unlike the traditional ones, they have flexible requirements and accept applications from non-U.S. citizens.
For other loan programs, you may consider these home loans for foreign nationals and other non-U.S. citizens.
To avail of a construction loan, you must have a detailed plan of what you expect to achieve throughout the lifetime of the loan. You should coordinate with your builder or contractor to prepare this plan, following your preferences for your home. This way, lenders will feel confident in the project and your ability to repay.
Since the house to be built will act as collateral for the construction loan, lenders need to know whether the anticipated value of the completed property would suffice for the loan. Therefore, the lender will have a third-party appraiser provide two values of your property: (1) the as-is value; and (2) the after-completion value or after-renovated value (ARV) once the construction is completed.
While it is easy to assume that the process of getting a construction loan is the same as any other mortgage, it is not often the case. Construction loans can involve more work and require more time and planning.
As a start, here are the factors to consider and requirements needed to secure a construction loan:
This item may sound easy, but keep in mind that your builder should have the expertise and license to perform the duties satisfactorily. Also, remember that lenders give preference to construction projects handled by companies or builders who have an excellent track record and are licensed to perform the duties.
Your builder should be qualified and licensed.
To find a competent builder, you may ask for referrals from your friends, family members, or colleagues. This is a good way to start because these people can give first-hand accounts of how their construction went and what they feel about the final results.
If your family or friends cannot give recommendations, you may then visit the directory of the National Association of Home Builders. There, you can find a list of builders for your specific area. They also provide the contact information of each builder, so you can reach out to them easily.
Once you’ve found a builder or company which you think might be a good fit, make sure to conduct your research and due diligence. Compare your options carefully. Your future home will be in the hands of your builder—literally and figuratively—so you should take time to pick the best one.
As expected, you will need to satisfy documentary requirements to proceed with your loan application. On the basic level, you may need proof of income, pay stubs, tax returns, credit history, bank statements, or rental history, if applicable.
Applying for a construction loan also entails providing these items:
When completing your application, your timeline should be as accurate and reasonable as possible and should take into account any expected delays. The reasons for delays may be hard to foresee, such as natural disasters, but your builder should have a better idea based on the existing conditions.
For example, home construction in 2021 faced considerable delays due to the limited supply of building materials. Because of the pandemic and the low interest rates, many people decided to improve their housing conditions which resulted in a shortage of lumber, aluminum, steel, and electrical materials. This bottleneck is expected to improve in 2022, but you should still discuss this aspect with your builder to ensure no significant timeline issues occur during the construction of your home.
It may sound counterintuitive to get homeowners insurance when the house itself is not yet standing. However, lenders require you to insure your home as early as possible during the construction stage so that whatever happens—fire, accident, theft, vandalism, etc.—you are protected.
Construction loans are more complex than other residential loans. The requirements, procedures, and loan terms vary from one lender to another. On top of the common requirements, additional documents relating to the construction project are also needed.
When searching and comparing your options, it is easy to get overwhelmed with all the information you are getting. But remember that you don’t have to do everything on your own. Mortgage brokers have the expertise and experience to make the process easier for you, so you can focus on the most important thing—the construction of your home.
