You’ve picked out a plot of land, settled on a builder and chosen the design for your new home. But how do you pay for it? You probably can’t get a standard mortgage, because the collateral — the home — doesn’t exist yet. This is where a home construction loan comes in.
A home construction loan covers the cost of building a new home — or sometimes major renovations to an existing house — and the land the home sits on. The loan typically lasts for 12 months and then must be paid off or converted to a standard mortgage.
Not all buyers of new homes need a home construction loan. A builder constructing multiple homes or developing a community may sell finished homes to buyers who obtain a standard mortgage or pay cash.
The process for getting a home construction loan is in many ways similar to the standard mortgage process, but in addition to underwriting your loan application, the lender will also need to vet the builder.
Types of Home Construction Loans and How They Work
The two most common kinds of home construction loans are construction-to-permanent loans and standalone construction loans.
Construction-to-permanent, or C2P, loans. Also called a one-step or single-close loan, a C2P loan automatically converts to a standard mortgage when construction is finished. The lender may call this conversion a modification or refinance, but the borrower does not have to go through the loan application process all over again.
The payment on a C2P loan might be a little higher than that on a similar standard mortgage. That’s because during construction the borrower typically pays interest only. Then, when the loan is converted to a standard mortgage, the payments sometimes are recast based on the amount of time remaining on the loan term.
For example, with some mortgages, if the loan converts to a 30-year mortgage and construction takes one year, the monthly payments will be calculated to pay off the balance over the remaining 29 years.
One advantage to the single-close loan is convenience. One loan entails less paperwork than two. Furthermore, you can save money, possibly a substantial amount, on closing costs by eliminating a second loan closing.
[Read: The Best Mortgage Lenders of 2018.]
Another advantage is that having a permanent loan secured early on means there is no question that you will be able to find a lender and loan when your home is ready. Even if you lose your job during construction, you will not be denied the mortgage. It’s already approved.
C2P loans do come with some drawbacks. Once you close the loan, for example, you cannot change your mind. Also, even though your lender will initially check out and approve your builder, if something goes wrong during construction, you are still responsible for the loan.
Standalone construction loans. This is a short-term loan that funds a home construction project. When construction is finished, you’ll need to pay the loan off. If you do not have the cash to do so, you will need to apply for a mortgage.
Having separate construction and mortgage loans allows you to shop for the best terms available at the time you apply for each loan.
A primary disadvantage of the standalone construction loan is that you will pay two sets of closing costs.
How to Qualify for a Home Construction Loan
Just like when you apply for a standard mortgage, you submit an application for a home construction loan and a loan underwriter will analyze your income, debts and credit history to determine whether you qualify, at what terms and for how much. Some lenders consider construction loans to be a higher risk than mortgages and therefore may impose stricter requirements or charge more in fees.
Documentation. Your lender will need all of the same documentation that is required for a mortgage. Required documents typically include:
— Proof of identity
— Recent pay stubs
— Proof of other income, such as alimony, child support, self-employment, Social Security or disability
— Recent tax returns
— Recent bank statements
— Recent statements for other assets such as brokerage or retirement accounts
— List of your debts with minimum monthly payments
— Other liabilities, such as alimony or child support payments
— Source of down payment
— Current rent or mortgage payments
— Profit-and-loss report if self-employed
Down payment. Jeff Williamson of Homeowners Financial Group USA in Scottsdale, Arizona, says that the down payment requirement varies by loan type. For a high-end custom home, expect to need a large down payment. “A one-time-close construction loan for a multimillion-dollar home usually requires 20 percent down.”
For a less expensive new home, the down payment requirement can be much lower. Private lenders may offer construction loans to qualified borrowers with a 5 to 10 percent down payment requirement. Government-backed loans are available with as little as zero down. Williamson says that the FHA, VA and USDA programs all offer one-time-close construction loans. These loans are subject to the same conditions as standard government-backed mortgages, such as applicant eligibility restrictions, loan limits based on location and income caps.
Keep in mind that your finances need to be strong enough to continue to pay your living expenses in addition to the payments on the construction loan while your new home is being built.
Builder requirements. “Your builder has to be approved,” says Danny Buckner, loan officer at Midland Mortgage in South Carolina. He says that the builder will need to supply the lender with a form listing references, including third-party vendors who can attest to the builder’s bill-paying history. “We don’t want to end up with a builder who is going to leave the house half-built.” The lender will examine the builder’s credit rating and financial standing and require copies of the builder’s professional licenses and proof of insurance.
Drew Huckeba, assistant vice president for mortgage services at SAFE Federal Credit Union in South Carolina, says that the lender will also need to see the builder’s final, approved plans. The lender does not approve or reject your plans, but a new home appraiser will review them, along with information on comparable properties, in order to determine the value of the finished home.
Home Construction Loan Process
Once the loan is secured, building typically starts right away. The loan funds, however, are not disbursed all at once. Instead, the lender doles out the funds in a series of draws as construction progresses. “The first checkpoint could be getting the foundation laid or starting the actual framing,” says Huckeba.
Builder draws. When your builder requests a draw, the lender will arrange for an inspector to verify that the relevant milestone has been reached. Before your lender releases additional funds, you should make sure that all subcontractors and suppliers have been paid by your builder, and collect signed releases of any mechanic’s liens against your property.
If your builder fails to pay subcontractors, their legal recourse is against you. You, in turn, would need to sue the builder to recover any losses. Your lender also has an interest in avoiding liens against the property and may already have a clause in its contract with the builder or a process in place for obtaining lien releases at every draw.
The borrower can and should participate in the process, all the way to the final inspection. Issues should be addressed in real time. “The borrower will sign off to say they got what they wanted,” says Huckeba. That is the point at which the final draw is released to the builder and the construction loan needs to be paid off or converted to a standard mortgage.
Borrower payments during construction. The payment schedule on most construction loans begins immediately after the loan closes, and borrowers typically make interest-only payments during construction. Interest is charged only on the amount that has been disbursed to the builder. “During the build, you can increase your payment,” says Huckeba, to make progress against the debt. He advises that you first verify that your lender does not impose a prepayment penalty.
[Read: The Best FHA Loans of 2018.]
Since the construction loan is in addition to existing household expenses, some borrowers prefer a payment that is as low as possible. Some lenders allow zero payments during construction, adding the interest charges to the permanent loan balance. This can help you manage your budget in the short term, but if you take advantage of this option, you will pay interest on interest for the life of your loan.
Once the loan converts to a standard mortgage, the payment changes to a principal-and-interest payment that is amortized over the remaining loan term.
When to Talk to a Lender About a Home Construction Loan
Most home construction lenders can recommend builders, and most homebuilders can recommend finance partners. You can start the process at either end.
To be sure that you are shopping in the right price range, start by getting preapproved by a lender and then make your wish list for a new home.
“It’s always best to get your finances in order first,” says Buckner. Securing financing can help you keep expectations in check. Without a budget, you might choose expensive options and then face the disappointment of cutting back. “You don’t want to get too excited over something you ultimately can’t have,” he says.
Huckeba advises the same strategy and says that SAFE Federal’s typical home construction loan customer starts with a conversation about financing. “They want to make sure they’ll be approved.” Many customers come in with an idea of the builder they want to use, but if they do not, the credit union can make referrals.
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