Everything You Need to Know About Construction Loans

Do you want to build your own home? Are you wondering how construction loans work? When it comes to real estate and mortgages, there isn't a one-size-fits-all choice. It all comes down to circumstances, and in this case, if you're constructing your own home, you're going to need a particular type of loan: a construction mortgage loan.

Here, we'll discuss what construction loans are and how they work, along with some of the types of loans that may be available to you, depending on what you need the funds for:

What Is a Construction Loan?

A home construction loan gives you the funds needed to build a house on a piece of land at a high-interest rate over a short period of time—typically a one-year period when the property is fully constructed.

Construction loans are used to cover all sorts of things that go into building a home: land, labor, permits and building materials.

Depending on the lender you choose, there can be different requirements you'll need to meet or limitations that you might find with the loan. For example, a construction loan doesn't usually cover the home furnishing aspect of a home, although it may cover things like permanent fixtures throughout the walls of the interior and necessary appliances, such as fridges and washing machines.

Home construction loans are used when you have purchased a piece of land and are ready to build. A land loan is often used when you want to buy land but aren't quite ready to construct your dream home.

How Does a Construction Loan Work?

Construction loans are higher than most mortgage loan rates, given the fact that with a traditional mortgage, your home acts as the collateral if you fail to make a payment, so the lender has something to cover the costs you've missed.

With a construction loan, the lender doesn't have this option. Because of this, lenders see this type of loan as a much higher risk, which is why interest rates are usually much higher. The money needed to put down is higher than the down payment requirements of resale homes. Usually, you'll need to have 20 to 30 percent down with a construction loan.

To be eligible for such a loan, you're going to need to give a lender a build timeline along with a detailed plan of how the project is going to go, including any and all costs.

Once the lender approves everything, they'll then put the borrower on a draft schedule depending on the project's planned process (as laid out previously)—meaning that the borrower will see payments as the project goes on. The payments are known as "draws."

This is different from something like a personal loan where the lender would give all of the funds at the beginning of the loan. Instead, lenders pay out during the stages of construction to cover the costs when they are needed as the house progresses—this is to protect both parties from the lender/owing too much money if the construction project falls through for whatever reason.

For example, when the foundation is complete and backfilled, you might get your first draw to pay the contractors who have performed this work. When the house is framed, you will get another draw and so on until the home is completed.

What Do Lenders Require to Grant a Construction Loan?

The following items will be required by lenders who are willing to do construction mortgages. Keep in mind that not every lender works with construction loan financing.

• You'll need a building contract between yourself and the builder, much like you would have a purchase and sale contract when buying a resale home.
• The lender will want a copy of the builder's license.
• You'll need a detailed set of blueprints of the house you plan on building.
• The bank will want a detailed list of how the house will be constructed—known as builders specifications. The lender will be looking at specific vital items such as the type of heating, cooling, electrical, plumbing, kitchen, baths and other extras.
• Any items outside the building contract that could impact value, such as swimming pools, outbuildings, sheds, specialty landscaping, etc.

It's also worth noting the lender will require a real estate appraisal to ensure the market value is where it needs to be. Just as they would with any other type of mortgage, the lender wants to ensure they lend on a property where the proper value exists.

Types of Construction Loans Available to You

Construction-Only Loan: This type of loan gives the borrower the necessary funds to finish the home. Still, the borrower must eventually pay back the entirety of the loan, which, as discussed, is usually less than one whole year; or they need to obtain another loan then to get more permanent financing.

For this reason, construction-only loans can be more costly as the money you're getting from the lender only covers construction fees. Eventually, you'll need a traditional home mortgage, which means that you're going to be paying back two separate loans.

Construction to Permanent Loan: Construction loans to a permanent mortgage allow you to get funds for the construction of the home. This loan can then be changed to a traditional mortgage loan once you move in, which is an advantage over the previous option as you're only going to be paying back one loan.

Another advantage of this type of loan also means you're only going to be paying back a single set of closing fees, which obviously reduces your overall cost.

Owner-Builder Construction Loan: This kind of loan is similar to the two previous loans except that the borrower is also acting as the builder of the project. Most lenders will not let the owner act as the onsite builder unless the borrowers hold specific licenses for the planned project.

Renovation Loan: If you're looking to renovate and change your home's look, then a renovation loan will be your best option. Unlike the other loans, the lender does not require any project plan from the homeowner as to how they might use the money. When you're making improvements around your property, this will be the way to go.

A construction loan is a valuable financing tool for those who want to construct their own home, whether it is a modular home or stick-built construction. By having construction financing, you'll put yourself in the position to build a home you want it built and not have to purchase one of the many cookie-cutter homes that are traditionally constructed in large subdivisions. Hopefully, you've found this guide to construction loans to be useful. Best of luck with your project!

Bill Gassett is a nationally recognized real estate leader who has been helping people buy and sell MetroWest Massachusetts real estate for the past 33 years. He has been one of the top RE/MAX REALTORS® in New England for the past decade. Gassett works for RE/MAX Executive Realty in Hopkinton, Mass. In 2018, he was the No. 1 RE/MAX real estate agent in Massachusetts.