What Type of Loan Do I Need to Build A New Home

Categories: Blog

Many people believe that building a new home is out of their reach if they do not have the cash to pay for the construction up-front, so they end up buying an existing home using a conventional mortgage. However, construction loans are available to help homeowners who are in this situation. Here is a look at what is involved in financing the construction of a new home.

Construction Loan Basics

banker helping young couple with construction loan optionsConstruction loans are typically short-term loans that cover the cost of building a home. While the home is under construction, the amount of the loan is released in phases as the work on the home progresses rather than in a single lump sum like other types of loans. These smaller installments are known as draws and are given to the builder as reimbursement for the construction costs as they go along. Before each draw is paid, the lending institution will perform its own inspection to estimate the cost and determine the project’s progress. During this time, the borrower will only be responsible for paying interest on the loan. This allows borrowers to keep their payments low at a time when they may be paying rent or another mortgage at their current residence, but the principal loan balance will not be reduced during the construction phase. A construction loan will typically come with variable rates that are higher than those attached to traditional mortgages. There are two main types of construction loans: a standalone construction loan and a construction-to-permanent loan.

Standalone Construction Loans

With a standalone construction loan, a borrower will end up having to acquire two separate loans in total. The first one is for the construction of the home and only covers the costs of building the house. Once construction is completed, a separate traditional loan will be needed.

Construction-To-Permanent Loan

Many borrowers decide to obtain a construction-to-permanent loan. With this type of financing, the borrower is only responsible for paying the interest on the loan while the home is under construction. Once the home has been built and the lender has inspected it, the interest-only payments will become full mortgage payments and the construction loan will be converted into a standard home loan. This is the preferred option for many borrowers because it enables them to get two types of loans in one, which means less paperwork and a more streamlined experience.

Applying for A Construction Loan

couple walking though their home that is getting buildBorrowers should expect to put some money down. With every lender the amount may be different. The construction loan application will require a project timetable and budget, along with a detailed list of the construction plans, including the floor plans and the types of materials that will be used. Borrowers should expect to pay at least 20 percent down on a construction loan, although some lenders will ask for 25 percent. This is because a construction loan poses a higher risk than a traditional mortgage because the house securing it does not yet exist and the lender needs to ensure that the borrower will not simply abandon the project, leaving them without any collateral. Borrowers will also need to have good credit in order to qualify for this type of financing. Although some people may be able to get this loan with a credit score of 680, many lenders prefer to see scores of 700 and higher before approving someone for this type of loan. When calculating the size of the construction loan, borrowers need to allow a margin for the possibility that the project may come in over budget, which is a common occurrence.

Borrowers Must Work With Qualified Builders

Lending institutions generally require that borrowers work with a qualified builder in order for their construction loan to be approved. This is typically a licensed general contractor who has an established reputation for building quality homes. Therefore, this is not a viable option for borrowers who plan to build their own home unless they can prove that they have the experience, licensing, and insurance to build the home themselves. Another type of financing may be more appropriate in cases where the borrower wishes to carry out their own construction. Owner-builder construction loans, which are also sometimes referred to as DIY home build loans, can be difficult to qualify for, but those with homebuilding skills who present a thoroughly researched construction plan and meet the loan requirements may find this to be a good approach.

Don't Forget About Closing Costs

The construction loan’s closing costs will vary depending on the loan's terms, but borrowers should expect to spend around two percent to five percent of the project's total price on closing costs.

Discuss Your Project With Woodsboro Bank

If you are ready to take the next step in making your home-building dream a reality, contact the construction loan experts at Woodsboro Bank to learn more about our financing options.