A construction loan is a short-term loan used to finance the building or renovations of a home or other real estate property. It provides funds to construct a new building or remodel, expand, or improve an existing building.
Construction loans work differently than traditional mortgages. With a typical mortgage, the borrower receives the full loan amount upfront to purchase a completed property. With a construction loan, funds are disbursed incrementally as construction progresses to ensure the work gets completed.
Construction loans allow borrowers to build and finance a custom home or other property tailored to their needs and specifications. The loan provides payment for land acquisition, materials, labor, permits, fees, and other costs incurred during the construction process.
These specialized loans serve an important role in real estate development by enabling new construction and renovation projects. They carry more risk than conventional mortgages, so lenders have stricter requirements and charge higher interest rates. Overall, construction loans provide an essential funding source for builders and investors seeking to develop properties.
How Construction Loans Work
Construction loan rates are a specific type of financing used to fund the building or renovating of a home or other property. The purpose of a construction loan is to provide money to pay for labor, materials, permits, and other costs associated with the construction project.
The process of getting a construction loan typically involves working with a lender to secure financing before the building phase begins. Borrowers will need to provide detailed plans, budgets, permits, and other documentation to apply for the loan. If approved, the lender will issue periodic payouts of the loan amount as certain stages of the construction are completed and inspected. This provides oversight on the project and ensures the funds are used as intended.
Construction loans are short-term loans that are paid off once the project is finished. At this point, borrowers will often get permanent financing to pay off the construction loan. This type of financing is essential for those looking to build a custom home or complete major renovations when the costs exceed available cash on hand. It allows the project to move forward while providing the lender some control over the process.
Types of Construction Loans
There are a few main types of construction loans to be aware of:
Single-Close Construction Loans
A single-close construction loan rolls the construction loan and permanent mortgage into one loan. This means you only need to close on the loan once. With a single-close loan, the construction period has a variable interest rate, and once construction is finished, it converts to a fixed-rate permanent mortgage.
Single-close loans allow you to lock in your long-term interest rate upfront. This provides stability and can protect you from rising interest rates during the construction period. However, single-close loans usually have stricter approval requirements.
Two-Close Construction Loans
With a two-close construction loan, you get a short-term loan just for the construction period. Once construction is finished, this loan must be paid off, and you’ll need to get a new permanent mortgage loan to pay off the construction loan.
Two-close loans offer more flexibility, as you can shop around for the best rates and terms on your permanent mortgage after construction is complete. However, you face some interest rate risk as rates could rise between closing on the construction loan and obtaining the permanent financing.
Owner-Builder Construction Loans
Owner-builder loans are designed for owner-builders who want to act as their own general contractor. This allows you to save on contractor fees, but requires you to manage the construction yourself.
Lenders usually have stricter requirements for owner-builder loans because of the increased risk. You’ll likely need a higher down payment and strong DIY experience.
Custom Construction Loans
Custom construction loans are for building a home from the ground up on land you already own. Rates and terms vary by lender. Custom loans allow you to build your dream home on your own property. However, they tend to come with higher rates and costs compared to loans for spec home construction.
Construction-to-Permanent Loans
Some lenders offer construction-to-permanent loans, which blend features of single-close and two-close loans. The construction portion has a variable rate that converts to a fixed-rate permanent loan after completion. However, you can still choose your own lender for the permanent financing.
This allows you to lock in an interest rate upfront while maintaining flexibility on your long-term financing. However, these loans are less common than traditional single-close and two-close products.
Construction Loan Rates
Construction loan rates are typically variable and pegged to a benchmark rate like the Prime Rate or LIBOR. This means the interest rate will fluctuate over the course of the construction loan as the benchmark rate changes.
The average interest rate for construction loans right now is around 5-7%. However, construction loan rates can vary significantly depending on a number of factors:
Credit Score – Borrowers with higher credit scores will qualify for lower rates, while those with poor credit will pay higher interest rates. A credit score of 700+ will get the best rates.
Loan-to-Value (LTV) Ratio – The LTV compares how much you plan to borrow to the completed value of the home. The lower the LTV, the better the rate.
Benchmark Rate – As mentioned, construction loans tie to a benchmark like Prime or LIBOR. The lower this underlying rate, the better for borrowers.
Construction Type – Custom-built homes are seen as higher risk than spec homes, so they may have a slightly higher rate.
Construction Loan Program – Government backed programs like FHA and VA loans can offer lower rates than conventional construction loans.
Relationship with Lender – Having an existing relationship with a lender through checking/savings accounts may help you get a lower rate.
The best way to find current construction loan rates is to shop around with multiple lenders. Compare their rate quotes and fees to find the best overall loan option for your construction project. Locking in your rate as soon as possible can help guard against rate hikes during the building process.
Construction Loan Fees
There are various fees associated with construction loans that borrowers should be aware of. These fees can add a significant cost to the loan, so it’s important to understand and budget for them.
Origination Fees
This is a fee charged by the lender to process, underwrite and close the construction loan. It’s typically 1-2% of the loan amount. For example, on a $200,000 construction loan the origination fee could be $2,000 – $4,000.
Inspection Fees
The lender will require periodic inspections of the construction by a third-party inspector. This helps ensure the work is being completed according to plan and reassures the lender that their investment is sound. Expect to pay inspection fees ranging from $200 – $500 per inspection. The number of required inspections varies by lender, but expect around five inspections over the course of construction.
Other Fees
There are also other fees such as:
Appraisal fee to value the land and completed property. Usually $300-$500.
Attorney fees for closing the loan. Typically $500-$1,000.
Title insurance and title work required to close the loan. Could be $1,000 or more.
Permits required by the local municipality for construction. Permit costs vary greatly but plan on several thousand dollars.
Loan extension fees if the project runs past the original timeline. Lenders charge a monthly fee to extend the construction loan period.
It’s important for borrowers to understand these fees and factor them into the total cost. Construction loans require more upfront costs compared to traditional mortgages. But with proper planning, these costs can be managed.
Construction Loan Requirements
Construction loans have several key requirements that borrowers need to meet in order to qualify and get approved. Here are some of the most important requirements to be aware of when applying for a construction loan:
Credit Score
Your credit score is one of the main factors lenders look at when reviewing a construction loan application. In general, you’ll need a minimum credit score of 620 to qualify for a construction loan, but scores of 700 or higher are ideal and will get you the best rates. The higher your credit score, the lower your interest rate is likely to be.
Down Payment
Most lenders require a down payment of around 20-25% of the total project costs for a construction loan. This down payment acts as your equity in the project. The more equity you have, the less risk for the lender. Some lenders may allow down payments as low as 10% for borrowers with excellent credit. The down payment must come from your own funds, as you cannot finance it with another loan.
Other Requirements
In addition to credit score and down payment, lenders also look at factors like your income, existing assets, debt-to-income ratio, employment history, and experience with construction projects. You’ll need to demonstrate you have enough income and assets to comfortably handle the construction loan payments. Having a lower debt-to-income ratio is better when qualifying. Most lenders also want to see that you have a reliable source of income as well as a history of managing other loans successfully. If you have experience with construction or renovations, that can work in your favor as well. Meeting all the requirements demonstrates you are a low-risk borrower.
Construction Loan Lenders
There are several types of lenders that offer construction loans, including:
Banks
Banks are one of the most common sources for construction loans. Large national banks like Bank of America, Wells Fargo, and Chase offer construction loans, as do many smaller regional and community banks. The advantages of getting a construction loan through a bank include established lending experience, low interest rates, and the ability to bundle your construction loan with other banking services. The downside is that bank loans often come with stricter approval criteria and more paperwork.
Credit Unions
Like banks, credit unions also commonly provide construction loans. Credit unions are member-owned nonprofits, so they may offer better customer service than large banks. Credit union construction loans often have lower interest rates and more flexible qualification requirements than banks. However, credit unions usually have less capital to lend than big banks, so individual loan amounts are lower. Credit unions are a good option for smaller construction projects.
Online Lenders
Online lenders like LendingTree and Lightstream offer construction loans directly to borrowers via their websites. Online lenders have minimal overhead, so they can pass savings on with lower interest rates. Approval is quick and applications are completely online. However, online lenders typically cater to borrowers with good credit and high incomes. Loan options may be more limited compared to banks and credit unions.
Construction Loan Process
The process of obtaining a construction loan generally follows these steps:
1. Pre-Qualification
Meet with a lender to discuss your project and financial situation. The lender will want to see your plans, budget, financial statements, and other documentation to determine if you qualify.
Get pre-approved for a loan amount based on your finances. This shows sellers you are serious.
2. Find Land and Finalize Plans
Once pre-qualified, you can start seriously looking for land and finalizing build plans if you haven’t already.
Lenders will want to review final plans before approving your loan. Plans impact the appraised value.
3. Loan Application
Formally apply for the construction loan once you have land and final plans. Provide financial records, permits, builder agreement, and other required documents.
The lender will order an appraisal of the property and proposed home to determine the loan-to-value ratio.
4. Loan Approval
If approved, you’ll receive a loan estimate outlining terms like fees, interest rate, and payment schedule.
Sign loan documents and pay any upfront fees to lock in your rate.
5. Closing and Initial Draw
At closing, the land deed transfers to your name and you can access the first construction draw.
An inspector verifies work completed before each subsequent draw. Draws are scheduled per the builder agreement.
6. Construction
Builder constructs the home per the approved plans and draw schedule. Lender may require inspections at key stages.
You’ll make interest-only payments on the loan during the construction period.
7. Conversion to Permanent Mortgage
Once construction completes, the loan converts to a traditional fixed-rate mortgage.
You’ll begin making principal and interest payments amortized over the loan term.
Following this process carefully ensures you receive funding at each stage of construction. Communicating closely with your lender and builder is key.
Construction Loan Risks
Taking out a construction loan carries some inherent risks that borrowers should be aware of. Being prepared and taking steps to mitigate these risks can help ensure a smooth construction loan process. Some of the key risks include:
Cost Overruns
It’s not uncommon for construction projects to go over budget. Unexpected costs for materials, labor, or delays can quickly add up. This puts borrowers at risk of not having enough money to finish the project. Having a sufficient contingency fund and getting a locked-in construction loan amount that exceeds the expected costs can provide a cushion. Closely overseeing the budget and timeline can also help avoid major overages.
Delays
Construction delays from weather, materials shortages, labor issues, or other factors can increase costs and extend the loan term. This results in more interest payments. Careful planning of the timeline and maintaining frequent communication with the construction team helps minimize delays. Build in a buffer to the timeline as well.
Value Depreciation
If the real estate market declines during construction, the completed home may be worth less than anticipated. This makes it harder to get a permanent mortgage after construction or recoup investments if selling. Seeking construction loans when the housing market is strong can mitigate some of this risk.
Lender Issues
If the lender experiences financial problems, it could freeze loan disbursements mid-project. Borrowers should vet lenders carefully for financial stability. Having a backup plan or alternative lender can help in case issues emerge with the primary lender.
With proper planning, financial contingencies, and careful oversight, borrowers can effectively manage the risks of construction loans. Understanding these risks upfront makes for a less stressful loan process.
Conclusion
Construction loans are a great financing option for building a new home or completing major renovations, but they require research and preparation. Borrowers need to shop around and compare rates, fees, requirements, and processes across multiple lenders. It’s also critical to understand the risks and plan accordingly with sufficient assets, credit, income, and contingency funds.
Overall, construction loans allow you to fully customize and create your dream home. But make sure you only work with reputable lenders and builders, closely manage the project, and don’t overextend your budget. Conduct thorough due diligence and consult professionals like lawyers, accountants, and insurance agents when needed. With proper planning and caution, a construction loan can successfully turn your property vision into reality.