Home construction loans make it possible to build a new home without having to pay in cash. Although the basic principle is the same, these types of loans are different from conventional mortgages. The risk is higher for the lender, which makes the entire process more complex and challenging to navigate.
For those looking to build a new home in 2018, here are three important things to know about construction loans.
1. There are Two Types of Construction Home Loans
There are two types of loans borrowers can take out when building a new home: standalone construction, or construction-to-permanent. Each has its own benefits and drawbacks.
Standalone Construction Loan
A standalone construction loan is typically a short-term loan, and it can be harder for some buyers to obtain one because there is no collateral. Which is why some opt to work with hard money lenders.
This type of loan has a variable interest rate and a maximum term of one year in most cases. Rates are generally higher than permanent loans, and lenders will require a “story” for the loan, which typically includes:
- A realistic budget
- Detailed plans for the building process
- A construction time-table
Borrowers need to have all of the building details ironed out and their ducks in a row if they hope to get approved for a standalone construction loan.
Once approved, the borrower will be placed on a draw schedule according to the project’s construction stages. The lender will send someone out to check on the building progress as more funds are requested.
Once the construction is complete, the borrower then transitions to a mortgage. With this type of loan, there are two closings.
Construction-to-permanent loans provide funds for the construction and then transition into a 30-year mortgage once the building is complete. With this type of loan, borrowers only have to pay closing costs once.
Because the risk is higher with this type of loan, more funds may be required from the borrower. Lenders may only be willing to front 80% of the costs – sometimes less.
Borrowers who already own their land can use the value in their property as equity.
With either type of loan, borrowers typically only pay interest while the home is being constructed.
2. A Home Construction Loan Requires a Future Value Appraisal
With a construction loan, appraisals are done through analyzation of the cost breakdown and home plans. In other words, the lender looks at what the property would be worth if it were existing already and built according to the outlined plan.
Here’s what Construction Loan Center has to say about future value appraisals:
“The appraiser uses the proposed home’s architectural plans in conjunction with the Cost of Construction Breakdown and the Materials List to find similar comparable sales in the area to determine the Future Value of the home to be built.”
3. Construction Loans Make Up a Small Percentage of the Market
Both types of construction loans (standalone and construction-to-permanent) only make up a small percentage of home loans. Because they are considered high-risk loans, lenders require impeccable credit scores (especially in today’s lending environment).
Local banks and credit unions will typically be more willing to accommodate borrowers looking to build a new home.