What is a home construction loan

Building your own home can be a wonderful and fun experience, but also a long and expensive process. However, most people can not afford the costs of building a house in advance, and getting a mortgage can be tricky. After all, you ask a bank or mortgage lender to give you money for something that does not even exist yet.

A standard mortgage loan will not reduce it – but you may be eligible for a special type of loan called a construction loan.

What is a construction loan?

What is a construction loan?

A construction loan is usually a short-term loan used to pay for the cost of building a house. It can be offered for a fixed term (usually about a year) to allow you to build your home. At the end of the construction process, when the house is finished, you will need to get a new loan to pay off the construction loan – sometimes called the “final loan”.

Essentially, this means that you have to refinance at the end of the term and take out a new loan of your choice (such as a 30-year fixed rate mortgage) which is a more conventional financing option for your newly completed home.

Qualify for a construction loan

Qualify for a construction loan

Banks and mortgage lenders are often suspicious of construction loans for several reasons. A major problem is that you have to trust the constructor. The bank or lender lends money for something that needs to be built, assuming it will have some value once completed.

If things go wrong – for example, if the builder does poor work or the value of the property goes down – then it could turn out that the bank made a bad investment and the property is not worth as much as the loan.

In an attempt to protect themselves from this problematic issue, banks often impose strict qualification requirements for a construction loan. These usually include the following provisions:

  1. A qualified builder must be involved. A qualified builder is a licensed general contractor with an established reputation in building quality homes. This means that you may find it difficult to find an institution to finance your project if you want to act as your own general contractor or if you are involved in an owner / builder situation.
  2. The lender needs detailed specifications. This includes floor plans, as well as details about the materials that will be used at home. Builders often draw up a complete list of all the details (sometimes called the “blue book”); details usually include everything from ceiling heights to the type of home insulation to use.
  3. The value of the house must be estimated by an appraiser. While it may seem difficult to appreciate something that does not exist, the lender must ask an appraiser to review the blue book and specifications of the house, as well as the value of the land on which it is built. These calculations are then compared to other similar houses with similar locations, similar characteristics and a similar size. These other houses are called “comps” and an estimated value is determined based on comps.
  4. You will have to pay a large down payment. Generally, a minimum of 20% is the minimum you need to get a construction loan. Some lenders require up to 25% off. This ensures that you are invested in the project and that you will not get away with it if things go wrong. This also protects the bank or lender in case the house does not prove to be as profitable as expected.

If you meet all of these criteria and you have good credit, you should be eligible for a construction loan. As a general rule, lenders also need information about your income (to make sure you can pay mortgage payments) and your current home, as they would with any type of standard mortgage.

How do construction loans work

How do construction loans work

Once you are qualified and approved for a construction loan, the lender begins to pay you the money he has agreed to lend you. However, they are not just going to give the money to the builder at the same time. Instead, a draw schedule is established.

draw

Drawings are designated intervals from which the builder can receive the funds needed to continue the project. There may be several draws during construction. For example, the builder can get the first 10% at the close of the loan and the next 10% after clearing and foundation. The next influx of money can occur once the house has been built, then the subsequent payments once the house is under the roof and sealed.

The number of draws and the amount of each are negotiated between the builder, the buyer and the bank. Generally, the first draw comes from the down payment of the buyer (so it is the money of the latter most at risk). It is also common that the bank requires an inspection at every step before handing the money back to the builder. This ensures that everything is on track and that the money is spent properly.

Once all drawings have been paid and the house is built, the buyer must obtain the final loan to repay the construction loan.

The construction loan rate

With a construction loan, as with all other loans, you must pay interest on the money you borrow. Generally, construction loans are variable rate loans, and the rate is set at a “spread” relative to the prime rate. This essentially means that the interest rate is equal to the prime rate plus a certain amount. If the prime rate is 3%, for example, and your rate is the prime plus one, then you will have to pay an interest rate of 4% (which would adjust to the change in the prime rate)..

In many cases, construction loans are also interest-only loans. This means that you only pay interest on the money you have borrowed instead of paying back part of the principal loan balance. This makes the payment of construction loans more feasible.

In addition, you only pay on the amount already paid. For example, if you borrow $ 100,000 and only the first $ 10,000 has been paid, you only pay interest on the first $ 10,000 and not on the $ 100,000. You have to make monthly payments for this loan – as for a conventional loan – so that your monthly payments start to be low when only a small amount has been borrowed, and increase gradually as more money is paid to your builder.

disadvantages

Construction loans allow you to build a house when you would not otherwise be able to do it. Building a house can be a great experience if you want to design something unique or specific to your needs and the needs of your family. However, obtaining construction loans also involves a much greater risk than just buying an existing home.

Some of the potential risks include:

  1. The house will not be completed on time and in the budget. If your house is not finished according to the schedule, you may have to pay extra for the rental unit or two longer mortgages than expected because you will not be able to move in. In some cases, the final payment of your loan construction will become due and you will have to pay a fee to extend this loan – at least until the house is finished and you can refinance a final loan.
  2. Once completed, the house is not worth at least its construction price.. You might encounter this unfortunate situation if the builder performs a bad job or if the global real estate market collapses. In this case, you must find additional funds when refinancing the construction loan in a final loan.
  3. You will not be able to qualify for a final loan. If your income or credit changes dramatically, you may not be able to qualify for a final loan, which will create a significant problem because construction loans are not meant to be permanent. When the project is completed, the balance has to be paid. This is essentially a lump sum mortgage, which means that you pay interest during the project, the remaining balance being due at the end. If you can not refinance to pay the entire balance – and the lender refuses to extend the construction loan to allow you to refinance one way or another – you risk losing the new home because the entry if you can not make the payment.

Final word

If you are ready to assume the risks of a construction loan and you have the financial cushion to help you through the jolts of the road, a construction loan may be the right choice for you to build the house. of your dreams.

However, if you are simply looking for a place to live, if you do not have the emergency funds needed to deal with construction difficulties, or if you are worried about the process of building your home, it may be better to just buy an existing home using a conventional loan. It is important to carefully weigh the risks and benefits to make sure that the choice you make is right for you.

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