When you are building your new home, the last thing you want is to be surprised by something you didn't understand about home construction loans. If you're considering building a custom home in the future, then read on! We will go over what construction loans are and how they work.

What Is A Construction Loan?

A construction loan is a short-term (higher interest) loan used to finance the building of a home. A traditional mortgage, on the other hand, covers an entire property and gives you ownership after your monthly payments are complete. Construction loans can be crucial for people who want to build their dream homes from scratch but don't have enough cash or equity in their bank accounts to put down a lump sum. These types of loans are usually around one year in duration, while the property is being built.

What Does A Construction Loan Cover?

A construction loan may be used to pay for the land, labor, materials, permits, and other expenses associated with a house building project. While home furnishings are not usually covered in a construction loan, permanent fixtures such as appliances and grounds may be included.

Home construction loans often will include a contingency reserve to cover unexpected expenditures that may occur throughout construction. This reserve balance also acts as a buffer in case the borrower decides to make any enhancements after the start of construction. It's not unusual for a borrower to want to update their counters or change their design slightly once the plans are finished, which would incur additional charges.

How Do Construction Loans Work?

Construction loans generally have variable interest rates that change in accordance with the prime rate. Construction loan rates are typically higher than typical mortgage rates. Because the lender does not have the option to seize your house if you default on your payments, they see these loans as greater risks compared to traditional mortgages.

Because construction loans are of such short duration and are contingent on the project's completion, you must submit a construction timetable, detailed plans, and a realistic budget to the lender. The bank will go through these documents in great detail. If your documents are not detailed enough, they will be rejected and your planning timeline will lengthen and your start date will get pushed out. Be sure and work closely with a reputable and experienced builder to avoid these avoidable delays.

The borrower will be placed on a draft or draw schedule that follows the project's construction phases, and he or she will generally be required to make only interest payments during the construction stage. Unlike personal loans that provide a one-time lump sum payment, the lender pays out the cash in installments as work on the new home progresses. This further mitigates their risk.

When major milestones — such as the laying of the foundation or the framing of the home — are completed, there are often draws. Until the building is finished, borrowers are only required to pay interest on any funds drawn up to that point.

Construction Loan Rates

Rates on construction loans differ considerably from company to company, and they are based on the borrower's creditworthiness, the loan amount, and the length of time repayments are expected. Furthermore, interest rates for construction loans are typically variable, which means that they change over time depending on an index, such as the prime rate.

Rates are generally around one percentage point above typical mortgage rates. Today, construction loan rates range from 3.25% to 4%. This is due to the fact that construction loans aren't secured by a completed property and are, as a result, more hazardous than traditional mortgages.

Types Of Construction Loans 

There are several different types of home construction loans available. If you're considering building a home, you'll want to have a keen understanding of these so you can choose the right one.

Construction-to-Permanent Loan 

Construction-to-permanent loans, sometimes known as single-close loans, offer the cash to construct your house and for your permanent mortgage.

To put it plainly, you borrow cash to pay for the cost of constructing your home, and after you move in, the loan is converted to a permanent mortgage.

The main advantage of the construction-to-permanent strategy is that you only have to pay one set of closing fees, which reduces your overall costs.

Once you complete construction, the construction loans transform into a permanent (and regular) mortgage, generally with a term of 15 to 30 years. Then you make payments that cover both interest and principle, just like a regular mortgage. There are also other alternatives for borrowers with modest incomes, including an FHA construction-to-permanent loan with less demanding approval criteria that can be particularly useful to some consumers, or a VA construction loan if you're a qualifying veteran. Check with your mortgage professional to see what options you qualify for.

Construction-Only Loan 

A construction-only loan finances the building of a home, but the borrower must either repay the loan in full at maturity (usually within one year) or obtain a mortgage to secure long-term financing.

The money is disbursed according to the proportion of the project completed, and the borrower is solely responsible for interest payments on the funds borrowed.

Construction-only loans are sometimes more expensive in the end because you must complete two separate loan transactions and pay two sets of fees. Closing costs are often thousands of dollars, so avoiding another set is beneficial.

Another consideration is that your financial status might deteriorate during the building process. You may not be able to get a mortgage later on if you lose your job or experience some other difficulty, and you may not be able to move into your new house.

End Loan 

An end loan is the homeowner's mortgage once the home is completed. During the construction stage, a construction loan is used and repaid after completion of the project. A borrower will then have to pay off their regular mortgage, also known as the end loan.

Some lenders do not provide a construction-to-permanent loan, which is a single closing. Some require a second closing to go into the permanent mortgage, or an end loan. If this is the case for you, it pays to shop around and see if other options are available to you.

There are a couple less common construction loans available. Ask your lender about Owner-Builder Loan, or Renovation Loans to see if either of those options is right for your situation.

Factors to Consider About Construction Loans

There are some considerations that you need to understand when looking at taking out a home construction loan.

Timeline Issues 

Talk to your builder and see if there are any projected or possible delays in the schedule for building the home. A lack of materials is one of the most serious problems facing current construction projects. According to a May 2021 poll by the National Association of Home Builders, more than 90% of builders have had difficulties obtaining appliances, lumber, and other materials.

Multiple Closings 

If you're planning to build a home, figure out if you want to go through the loan process once with a construction-to-permanent loan or twice with a construction-only one. Consider how much additional borrowing costs and other fees would cost the project if you take out multiple loans.

When obtaining a construction loan, you must take into account the building of the house as well as the purchase and future management of the property. In that scenario, a construction-to-permanent loan might be useful to avoid multiple closings because you'll have to worry about financing for both your home and your new project at once. If you already

Homeowners Insurance 

Even if you do not yet reside in the home, your lender will almost certainly demand a prepaid homeowners insurance policy that covers builder's risk. You'll be secure in the event of an occurrence while building, such as a partially completed property catching fire or being vandalized.

How To Get A Construction Loan

How To Qualify For A Construction Loan 

Obtaining authorization for a building loan might seem similar to obtaining a mortgage, but breaking ground on a brand-new house is more complicated than getting approved for an existing home. Expect your finances to be more thoroughly examined than if you applied for a standard mortgage.

Here are some steps to take to help get a home construction loan:

  1. Review your credit score
  2. Cut your debt-to-income (DTI) ratio if possible
  3. Be ready to put down a sizable down payment
  4. Find a licensed builder
  5. Work with a builder to create the requirements for your home
  6. Project and construction budget approval
  7. Get your documents together.
  8. Get pre-approved through a lender.
  9. Work with your builder to decide on a start date.

Conclusion

Finding the best way to borrow money for your next home doesn't have to be difficult. Look into all of your options, figure out what type of loan is appropriate for your unique requirements, and shop around for the lowest price.

Be sure and check with Bianchi-Tillett Developers as they have preferred status with lenders and can direct you to the top lenders in the Sacramento area.

Finally contact us today for a free consultation and get all the details about building your new custom home!

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