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Apply for a construction loan - Why, when, and how to

Apply for a construction loan - Why, when, and how to

What is a construction loan?

Construction loans are normally opted by homebuilders or new homebuyers. These are short-term loans with the tenure of maximum 1 year. Construction loans are taken out for making payments of construction costs and other necessary expenses during the entire construction period.

Construction loan interest rates are variable, which normally change with the prime rate and are higher than the conventional mortgage rates.

When construction loans are taken out ?

As mentioned earlier, this loan is solely meant for construction cost purpose, so as a buyer you can apply for this loan to cover up below given costs.

Different home projects occur different costs, but there are few common ones:

  • The cost of construction land
  • Labor costs and machinery costs
  • Cost of materials
  • Cost of making the plan, work permit, and associated fees
  • Interest reserves (to pay only the interest during the construction work)
  • Contingency reserves (if it costs more than what you expected)
  • Closing costs of the loan

Home construction loans types:

There are mainly two types:

1. Construction-to-permanent loan:

In this case, you can take out a construction loan and need to pay only the interest part during the construction period. When the work is done and you move in, the lender will convert the loan into a conventional mortgage. Typically it’s a two-in-one loan. As a buyer, you need to pay one closing cost that’ll reduce the fee amount you pay.

The interest rate might vary with the change in the prime rate.

When the construction loan is converted to normal mortgage, you have the option to choose a fixed-rate or an adjustable-rate.

At the very beginning of the construction, as a borrower, you’ll have the option to lock a maximum mortgage rate.

Construction-to-permanent loan lenders might ask for 20% - 25% down payment as per their requirements.

2. Stand-alone construction loan:

A stand-alone construction loan is for only the construction period; it doesn’t cover the financing when you start living in the house. The repayment period of the loan is short.

That means the total amount will be due when the building is complete.

You may need to apply for permanent financing all over again. So, the closing cost will be double.

What are the requirements for a construction loan approval

The approval process is tricky. The borrower must have a clear idea ready on construction timetable, plan details, and the calculated budget before applying for the loan.

The lender will verify all those required aspects before giving the approval for a construction loan. During the construction period, the lender might also check on the resources which the borrower will use for funding the monthly payments.

Once approved, the borrower will get a bank draft or draws scheduled as per the construction stages. The number of drafts or draws is settled between the lender, borrower, and the builder.

Borrower normally need to make only interest payments during the construction.

Typically, the first draw is generated from the down payment provided by the buyer. After each draw, the lender might also inspect the construction work progress before releasing the next draw.

How to qualify for a construction loan

Lenders or banks have some strict qualifying requirements for borrowers regarding a construction loan. Typically, borrower must fulfil following provisions to qualify:

1. A big construction loan down payment is needed from the buyer

Buyer must put minimum 20% down payment for a construction loan. But some lenders might ask for 25% as well.

If you being a buyer, maintain all these criteria and have a good credit score in your pocket, it would be easy to qualify for a construction loan.

2. Detailed information must be conveyed to the lender

As a buyer, you must provide all the information with the lender while applying for the loan. The information may include floor plans, material quality and quantity that are going to be used, labor wages (approx.) transportation of the materials, permission for the machinery, home insulation, power supply costs and many more. Builders often form a list called the “blue book” and include all those details over there.

3. Buyer must appoint a qualified builder

A licensed, qualified builder must be appointed for the construction work. A reputed builder can give you assurance for building a quality home for you. Apart from that, a reputed, professional builder will also provide proper suggestions related to the construction work, and also render trustworthiness to the lender.

4. Buyer must appoint an appraiser to estimate the home value

The lender appoint an appraiser to evaluate the “blue book” and specs provided by the builder. The estimated value of the land will also be considered. The final report from the appraiser is compared side-by-side with the values of the houses in the same location, sizes, and facilities. These other houses are called “comps” and an appraised value is calculated based on the comps.

Compare construction loan with conventional mortgage

Construction loan

  1. Down payment - 20%–25%
  2. Interest rate - High
  3. Loan disbursement - Incremental
  4. Loan qualification - Complicated
  5. Lender requirements - Building plans, construction contract, estimated costs, and many more

Conventional mortgage

  1. Down payment - 3.5%–20% (depending on mortgage type)
  2. Interest rate - Low
  3. Loan disbursement - One lump sum
  4. Loan qualification - Less complicated
  5. Lender requirements - Personal financial information and credit score

Normally, you might need to inform about your monthly income to the construction loan lenders. It is because like other conventional mortgage lenders, they must also consider your affordability before approving your construction loan application.

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