Your Ultimate Guide to Construction Loans

Building a new home is an exciting journey, filled with possibilities and dreams taking shape. One of the crucial steps in turning these dreams into reality is understanding the financial tools available to you, particularly construction loans. This comprehensive guide will take you through everything you need to know about construction loans, how they differ from traditional mortgages, and how to manage them effectively as you build your new home.

Introduction to Construction Loans

A construction loan is a short-term loan used to finance the building of a home or another real estate project. The key feature of a construction loan is that it provides funding in stages. Unlike traditional mortgages that provide a lump sum for buying a property, construction loans are disbursed in increments as the construction progresses. This structure is particularly useful because it aligns the funding with the various phases of the building process, ensuring that funds are available as needed while also protecting the lender’s investment.

How Construction Loans Differ from Mortgage Loans

Construction loans differ from mortgage loans in several fundamental ways:

• Disbursement: While mortgage loans are typically disbursed as a single lump sum at the time of property purchase, construction loans are disbursed in multiple draws as construction milestones are reached.
• Term: Construction loans usually have a term of one year or until the construction is complete, which is much shorter than the term of a standard mortgage.
• Interest Rates: Due to the temporary nature and higher risk associated with construction loans, their interest rates are generally higher than those of traditional mortgages.
• Collateral: Your future home serves as collateral for a construction loan, but since it does not exist yet, the loan is considered riskier by lenders and, as a result, has higher interest rates.

The Construction Loan Process

Navigating the construction loan process can be complex, but understanding it in stages can make it more manageable. Here’s what you need to know:

1. Pre-Approval: Like with most loans, the first step is getting pre-approved by a lender. This involves verifying your credit score, income, and other financial credentials. See below for key factors lenders consider.
2. Choosing a Builder: Most lenders will require that you work with a licensed and approved builder. This is crucial as the builder’s credibility and track record become part of the loan approval.
3. Detailed Plans and Specifications: You will need to present detailed plans and specifications for your home. This includes blueprints, the type of materials to be used, and all other details relevant to the construction.
4. Appraisal: An appraisal will be required to estimate the future value of the home. This helps the lender understand the value of the project upon completion.
5. Loan Disbursement: Once approved, the loan amount is typically dispersed in stages depending on the construction milestones.

Key Factors Considered by Lenders

• Credit Score and History: A good credit score is crucial; it influences the loan’s terms and interest rates. The higher your credit score, the more favorable interest rates and terms are. Lenders prefer borrowers with strong credit histories as it reduces their risk.
• Debt-to-Income Ratio (DTI): DTI is a critical measure lenders use to assess your financial health. It compares your total monthly debt payments to your monthly gross income. A DTI ratio of 43% or lower is typically preferred, though some lenders may allow higher ratios.
• Down Payment: Expect to need a substantial down payment for a construction loan—often 20-25%. A larger down payment decreases the lender’s risk, potentially improving your loan conditions. You can begin to plan your financing using this construction loan calculator.
• Future Appraised Value of the Home: Lenders need assurance that the completed home will be worth at least as much as the loan amount. They use appraisals to estimate this value, which also influences the maximum loan amount they are willing to offer.
• Builder’s Qualifications and Project Feasibility: Your builder’s qualifications are scrutinized to ensure they have the experience and capabilities to complete the project successfully. This is why you want to make sure your builder is knowledgeable, reputable, and appropriately licensed and registered. Lenders will also want proof of your builder’s risk insurance. The project’s overall feasibility, including timelines, budget, and compliance with local regulations, is also a factor.

FHA One-Time Close Construction Loans

Some lenders are able to offer FHA One-Time Close (OTC) Construction Loans, which are Federal Housing Authority (FHA) backed construction-to-permanent loans up to $498,257 (as of the time of this writing) with as little as a 3.5% downpayment (with a 580+ FICO score) or 10% (with a FICO score of 500 – 579). Some FHA lenders may require a FICO score in the mid-600s for this type of loan. You can read about this in the FHA Single Family Housing Policy Handbook.

Typical Terms and Interest Rates

Construction loans are generally given for a term of 12 to 18 months, covering the construction period. The interest rates for these loans are typically higher than standard mortgage rates to account for the increased risk. Interest is usually charged only on the portion of the loan that has been disbursed. At the time of this writing, loan rates [1] ranged from 4.99% – 7% and APRs [2] ran from 6.311% – 8.245% (please see the footnotes for a description of these two rates). 

Repayment of the loan typically begins immediately with interest payments. Once construction is complete, the loan balance is either paid in full by the homeowner or converted into a mortgage, which will then start amortizing as per the agreed-upon terms.

Repayment Terms for Typical Construction Loans

During the construction phase, you only make interest payments on the amount of money that has been disbursed. This interest-only payment period helps to manage cash flow during construction when you might also need to cover additional expenses such as rent or storage.

Once the construction is completed and the full loan amount has been disbursed, you have two choices depending on the type of construction loan you have:

• One-Time Close Construction Loan: This loan automatically converts into a mortgage at the end of the construction. This is ideal as it locks in the mortgage rate at the beginning. This option also allows you to avoid 2 separate closing costs.
• Two-Time Close Construction Loan: This requires the homeowner to refinance the construction loan into a new mortgage, possibly at a new rate which could be higher or lower depending on market conditions.

Understanding construction loans is critical to planning your home building project. With the right information and a trustworthy lender, you can navigate this complex process with confidence. At Casper Builders, we are committed to helping you understand your building options and guiding you through every step of your home construction journey.

If you’re ready to start your home building adventure, or if you need more information on our services, visit our website or contact us today. Let us help you build not just a house, but a dream home where lifelong memories will be made.

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1. Loan Rate: The loan rate, often referred to as the interest rate, is the percentage of the principal amount that a lender charges for the use of its money. It’s the cost you pay to borrow the funds. For example, if you borrow $10,000 at a 5% annual interest rate, you’ll pay $500 in interest each year.
2. APR (Annual Percentage Rate): The APR is a broader measure of the cost of borrowing because it includes not only the interest rate but also any additional fees or charges that are associated with the loan. These may include origination fees, points, broker fees, etc. APR gives you a more comprehensive picture of the total cost of borrowing over the loan term. It’s expressed as a percentage and includes both the interest rate and any applicable fees. This rate is the true cost of borrowing and should be used in your calculations.