Construction loan for building of a home or Real Estate Project (Self-build loan)

Martins Chima

What is a construction loan and how does it work? Construction loan is for building of a home or real estate project normally known as self-build loan. When you want to buy a land to build a new home, office or do some renovations to a property you’re purchasing, you need more money. This is when a different type of financing comes into play – the construction loan.

A traditional mortgage helps you buy an existing home, but a construction loan is tailored to fund the building process or extensive alterations to the property.

Construction loans provide the necessary funds to cover the various phases of construction – from land acquisition and site preparation to the actual building work. These loans differ from standard mortgages as they are typically temporary and disbursed in stages, known as “draws,” to coincide with construction milestones. This ensures that the funds are allocated appropriately and as the work progresses.

It’s important to note that construction loans require a comprehensive understanding of your project’s scope, cost, and timeline. Lenders will assess the project’s feasibility, your qualifications, and the potential value of the completed property. The construction process involves collaboration between you, the builder or contractor, and the lender, ensuring that the project meets quality standards and remains on track.

Once construction is completed, the construction loan may be converted into a permanent mortgage, by converting the financing easily from the construction phase to homeownership. This process is known as “construction-to-permanent” or “one-time close” financing.

What I’m explaining in essence is that, a construction loan serves as the financial backbone for turning your vision of a new home or renovations into a reality. It provides the means to move the construction process efficiently while aligning with your financial goals and aspirations for your future living space.

What is a Construction loan in Real Estate Mortgage?

Construction loans are short-term loans used to fund the building of a home. It is commonly referred to as a “self-build loan,” or of short-term financing that is specifically designed to facilitate the construction of a new home or other real estate projects. This type of loan is given to both builders and personal home buyers companies going on a construction project and need financial support to cover the initial expenses.

Unlike regular mortgages, which approximately last for 30 years, construction loans typically have much shorter terms, usually for one year. Apart from relatively lower interest rates you can get from conventional mortgages, construction loans involve an adjustable rate that tends to be higher.

The reason for the high interest rates on construction loans is because of the risk that lenders take. In the case of construction loans, there isn’t an existing home that can serve as collateral, which is a higher level of risk for the lender. As a result, they impose higher interest rates to compensate for the increased potential risks associated with these types of loans.

How do construction loans work?

After you submit your application for a construction loan, you will provide the lender with a detailed project timeline. It is not like traditional mortgages, where you collect all the cash at once. In the construction loan type, funds are disbursed to the builder in stages throughout the construction process, following the timeline you’ve provided.

These staged payments are often referred to as “draws” by the lender. Therefore, for you to ensure progress and quality, an inspector or appraiser will assess the construction before each draw is authorized.

During the construction phase, most lenders typically require you to make interest-only payments on the loan. The next stages depends on the specific type of construction loan you have chosen.

You can Compare Personal Loan Rates for further understanding.

What does Construction loans cover in Real Estate Project?

Since a construction loan is different from a regular mortgage, it covers all the expenses of constructing the home/building. They are:

Land
Permits
Building materials
Labor
Contingency reserves

There is option for extra money you can also get in case you think of something you want to add to your plan after you’ve started the building process.

What are the Types of Construction loans for Building

1. Construction-to-permanent loan

You may choose a construction-to-permanent loan that involves converting the construction loan into a standard mortgage once the building is finished.

During the construction phase, your payments will likely be limited to the interest, and the loan will have an adjustable interest rate. However, by the end of the construction period, you will not have fully repaid the initial borrowed amount, or the principal.

The principal will then be integrated into your regular mortgage, and you can select between an adjustable or fixed interest rate. Subsequently, you’ll commence making monthly payments that encompass both the principal and interest.

Therefore, if you choose a construction-to-permanent loan, you speedup the process by applying for a single loan, and you’ll only be responsible for a single set of closing fees.

2. Construction-only loan

With a construction-only loan, you get financing specifically for the construction phase, without the subsequent conversion into a regular mortgage.

Typically, during the construction period, you’ll likely be obligated to cover only the interest. Upon the project’s completion, you’ll settle the principal amount in a single lump sum. This option could be beneficial if you have allocated savings to entirely pay off the construction loan at once, or if you intend to secure a separate mortgage to clear the loan.

Do not forget that not all lenders provide construction-to-permanent loans. Therefore, if you have a preferred lender for your mortgage that doesn’t offer construction-to-permanent loans, you might opt for a construction-only loan.

Nevertheless, this loan type comes with its own set of drawbacks. As you need to arrange a separate mortgage subsequent to the construction loan, you’ll need to navigate the application and approval processes twice. Additionally, you’ll be responsible for two rounds of closing costs.

3. End loan

End loans are works closely with construction-only loans. The term “end loan” pertains to the permanent, long-term mortgage that takes the place of your construction-only loan once your house is finished.

It’s important to keep in mind that the end loan is distinct from the construction loan. Consequently, you will undergo two separate closings: the first for the construction loan and the second for the permanent mortgage.

4. Owner-builder construction loan

When you, as the borrower, are personally overseeing the construction process, you will seek an owner-builder construction loan. However, it’s important to note that not all lenders offer approval for this type of loan. To be eligible for building the home yourself, you generally need to possess a construction license and have a professional background in the construction industry.

5. Renovation loan

Generally, choosing a renovation loan is a wise choice when you’re buying an existing home and have substantial modifications in mind, such as adding an extra room. With a renovation loan, the costs of your intended changes are integrated into your mortgage. This streamlines the process, allowing you to apply for a single loan and pay closing costs just once.

While there are other options like personal loans to fund home renovations, a renovation loan often boasts a more favorable interest rate compared to personal loans. Furthermore, the lender’s involvement in the renovation process is notably higher with this type of loan. This increased involvement is because the lender requires a clear understanding of your project timeline and how you intend to allocate the borrowed funds.

Related Mortgage Terms

What are Construction loan rates in Real Estate?

Construction loan rates are variable in nature, meaning they are subject to change based on the index they are linked to, such as the prime rate.

In general, construction loan rates tend to be higher than mortgage rates. This difference in rates stems from the fact that mortgages are backed by the home itself, providing a form of security for the lender. However, in the case of construction loans, the property has not yet been constructed, leading to a higher level of risk for the lender. Without a completed home to serve as collateral, the lender’s risk increases, resulting in higher interest rates for construction loans.

How Much is construction loan rates?

Construction loan rates can vary widely depending on several factors, including the lender, the type of construction loan, current market conditions, and your financial profile. Construction loans are typically short-term loans that provide funds for building or renovating a home.

Here are a few key points to consider:

Type of Loan: Construction loans come in different types, such as construction-to-permanent loans (which transition into a mortgage after construction) and stand-alone construction loans. Each type may have different interest rate structures.
Interest Rates: Construction loan interest rates can be higher than traditional mortgage rates due to the added risk for lenders. They might also come with variable interest rates that can change over time.
Credit Score: Your credit score and financial history play a significant role in determining your interest rate. A higher credit score could lead to a more favorable rate.
Down Payment: Lenders may require a larger down payment for construction loans compared to traditional mortgages, which can influence your interest rate.
Lender and Market Conditions: Different lenders might offer different rates, so it’s essential to shop around. Market conditions, including economic factors and the state of the real estate market, can also impact rates.
Loan Amount and Terms: The amount of the loan and the length of the loan term can influence the interest rate.
Location of the property: Construction loan rates can also be affected by the region or state where you’re building.

To get an accurate idea of current construction loan rates, it’s best to reach out to multiple lenders and discuss your specific project and financial situation. Keep in mind that rates can change frequently, so be prepared to do some research and comparison shopping.

Top Mortgage Guide to help you choose:

Eligibility of Construction loan: Who qualifies for a construction loan?

Before you proceed with applying for a construction loan, it’s essential to start by having a detailed discussion with your chosen builder. This conversation should cover critical aspects such as your budget, project timeline, and any necessary permits.

When you move forward with your application, the lender will thoroughly assess your plans, financial situation, and the builder you’ve selected. Due to the inherent risks associated with construction loans, lenders meticulously examine these factors.

Notice that the approval process might also consider the credibility of your chosen builder. Choosing for a builder with a good track record and a history of completing projects on schedule is very important. If you give your lender a wrong timeline and later discover that your chosen builder has a reputation for project delays, it will potentially work against your favor.

Just like the regular mortgage application, lenders will review specific aspects of your financial profile to determine your eligibility for the loan. Specific requirements depends on lenders, but you will likely need to meet the following criteria:

Credit Score: Generally, a credit score of 680 or higher is preferred.
Debt-to-Income Ratio: Typically, a ratio of 45% or lower is desirable.
Down Payment: For a construction-to-permanent or construction-only loan, a minimum down payment of 20% is usually required, though some lenders may ask for more. However, in the case of a renovation loan, a significantly lower down payment might be acceptable. For example, if you’re considering an FHA 203(k) Rehab Mortgage, only a 3.5% down payment might be required.

Best Methods to Choose a Construction loan lender

Choosing a suitable lender that will offer you the specific type of loan you require may require some effort. Just know that not all mortgage lenders provide construction loans. Among those that do, not all offer construction-to-permanent loans. If you intend to personally manage the construction process and need an owner-builder construction loan, your options might be small.

Your initial task involves identifying lenders that are open to your credit score, debt-to-income ratio, and down payment parameters. Once you’ve compiled a list of potential lenders, the next step is to seek pre-qualification or pre-approval from your top choices. This process allows you to compare the interest rates they offer.

Furthermore, request a detailed breakdown of the associated fees from each lender. This step is crucial in assessing whether lenders with seemingly similar interest rates may have significantly disparate fee structures.

Try your best to diligently choose the most suitable lender and the specific construction loan that aligns with your unique circumstances. This will help you to make positive progress toward the realization of your dream home construction project.

Frequently Asked Questions

What type of loan is best for construction?

When embarking on a home construction project, the optimal choice of construction loan hinges on your specific requirements and the options accessible to you. Determining the best fit involves weighing factors such as your financial needs and the available loan types.

For those seeking a streamlined approach and reduced closing costs, a construction-to-permanent loan holds appeal. This option is particularly advantageous for people who intend to move from construction loan to a permanent mortgage once the home is completed. On the other hand, if your intention is not to make use of a mortgage to settle your construction loan, a construction-only loan may be better with your plans.

Ultimately, your decision should be based on a careful assessment of your financial circumstances, future plans, and the benefits each type of construction loan offers.

What are the disadvantages of a construction loan?

Construction loans are regarded as more precarious from a lender’s perspective, leading to the imposition of higher interest rates to offset this risk. Additionally, construction loans are not as prevalent as other types of loans, resulting in potential difficulty in locating such loans and encountering more stringent qualification requirements.

What is the difference between a construction loan and a regular loan?

A construction loan is different from a regular mortgage primarily in terms of its shorter duration and the disbursement and repayment of funds. Construction loans typically lasts one year, whereas the average mortgage extends over 30 years. Throughout the home construction phase, funds from the construction loan are released gradually to cover different construction stages. During this period, the borrower usually makes interest-only payments. Once the home is finished, the borrower repays the construction loan, often through a permanent mortgage or profits made from sales of another home.

What should your credit score be to get a construction loan?

In most cases, a minimum credit score of 680 is necessary to be eligible for a construction loan, although certain lenders might demand higher scores.

Is it easier to get a loan to build or buy?

Obtaining a loan to purchase an existing home is typically easier compared to securing a loan for constructing a new house. Construction loans tend to be riskier, more challenging to qualify for, and come with higher costs.

Will the bank let me be my own general contractor?

Banks usually only permit borrowers to act as their own general contractor if they have a professional background in construction and are applying for an owner-builder construction loan. For individuals without construction expertise, it’s uncommon for banks to provide loans for self-building a home.