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Construction Loans: How They Work and What You Need to Know

Construction Loans: How They Work and What You Need to Know

August 31, 2022 by X2 Mortgage

Construction loans are a special type of loan used to finance the construction of a new home, renovation of an existing home, or other real estate projects. These loans have different terms and conditions than other types of loans.

So, if you're considering undertaking a construction project, it's important to understand how construction loans work and what you'll need to qualify for one. Let's discuss the basics of construction loans and what you need to know before applying.

How Construction Loans Work

A construction loan is usually granted to individuals looking to build a private residence, an office building, a housing development, or a shopping center. Typically, the lender will evaluate the property to estimate its potential value upon completion based on the location, kind of house being built, and current selling prices of comparable homes in the region.

Once your loan is approved, you will not be given the loan amount in one lump sum. Rather, a construction loan is often paid out in draws. These draws, which function more like a line of credit, are obtained at various stages of the building process or as a percentage of the project's completion.

To gain access to draws at each stage, the lender will request frequent inspection reports and other documents to confirm that the construction project is on track and that the money is being used for legal building purposes. Once the progress is validated, the lender approves a certain amount for the completed phase, and your contractor is paid just for the work done.

That means a construction loan is often paid directly to the contractor and not the borrower or homeowner. To decide the draw schedule, the lender, contractor, and borrower must all agree. However, the lender has the ultimate decision on the draw schedule.

Also during construction, you are only required to pay monthly interest on the amount of funds you have used, not the total loan sum of the entire project. However, after the construction, the loan term ends and sometimes you will want to refinance the construction loan into a traditional loan or apply for a new mortgage to pay for the completed property. It all depends on the scenario.

A construction loan is usually issued between 9 and 18 months and has variable interest rates that can change with the prime rate. Also, the interest rate is often higher than that of a regular mortgage loan. This is because lenders consider the construction loan as a higher-risk investment.

Types of Construction Loans

Understanding the differecent types of construction loans will assist you in choosing the best loan option for you.

1.  Construction-to-Permanent Loan

Also known as a One Time Close Loan, this construction loan is used to fund the construction and then converted into a permanent mortgage without the need of a refinance.

During the construction phase, a borrower makes interest-only payments. Once completed, the loan automatically converts into a standard 15 or 30-year mortgage in which the borrower pays principal and interest. The borrower can also choose between a fixed-rate mortgage and an adjustable-rate mortgage.

The primary benefit of this type of construction loan is that it reduces closing costs and secures mortgage financing.

2.  Construction-Only Loan

This is also referred to as a Two Time Close Loan. It is usually issued for a year and provides funds only for the actual construction. A borrower is also required to pay off the loan in full at the end of the construction.

To do that, most people will typically apply for a traditional mortgage and pay a second set of closing fees.

While this may appear to be an expensive option, it may be a good option if you have enough cash on hand or have (and intend) to sell a previous property to pay off the loan sum.

3.  Owner-Builder Loan

This type of loan is available to prospective homeowners who can demonstrate that they have building experience and do not require a contractor's services to oversee their homes' construction. 

As a result, the borrower is the owner-builder and receives the loan sum directly rather than through a third-party contractor.

To be approved for this loan, an owner-builder must provide evidence of previous projects and his/her home builder license (typically a GC license).

4.  Renovation Loan

Also known as FHA 203(k) loans, a renovation loan is similar to a traditional mortgage. It is used for home improvements and is insured by the Federal Housing Administration (FHA).

It is available to a homebuyer who wants to purchase and renovate a home. The approved loan sum will be based on the home's projected value upon completion.

In this type of loan, the borrower also serves as the house builder and must make a single monthly payment to cover both interest and principal loan sum.

What Are the Requirements For A Construction Loan

Unlike traditional mortgages, where your house serves as collateral, and a lender can seize the house if you fall behind on payments, there is no existing property that can be used as collateral for a construction loan. As a result, lenders consider this loan a higher risk and often impose more stringent eligibility requirements.

Financial Requirements

To qualify for any loan, you need a good credit score, a low debt-to-income ratio, and a verifiable and sustainable source of income. The minimum credit requirement for a construction loan is typically a 680 FICO Score. However, some lenders may require a score of at least 720 FICO.

Most lenders will also require you to have a DTI ratio of no more than 45%. Similarly, they will often want to assess your financial capability. Therefore, you will be required to present financial statements and other documentation confirming your annual income.

Down Payment Requirement

Although the down payment requirement varies by lender, most lenders need a 20% minimum down payment on a construction loan. However, some lenders may demand as much as 25% to 30% of the overall building cost.

Luckily, at X2 Mortgage, we have One Time Close Construction Loans that allow for as little as 10% down!

       Project Documents

To be approved for a construction loan, a lender will also require sufficient details on the proposed building project, including a deed (or purchase offer) for the land, detailed building plan, construction budget, construction timetable, a signed construction contract detailing the responsibilities of every party involved in the project, a proposed payment (draw) schedule, and a detailed appraisal containing a projected estimated value of the property once completed.

Builder or Contractors Approval

You must also show the lender that your contractor or builder is qualified, licensed, and insured. As a result, you need to provide copies of the builder's insurance certificates, a resume, and proof of financial stability.

Finding a Construction Loan Lender

Because of the risk associated with providing a construction loan, not many lenders offer it. As a result, you may be tempted to go with the first lender you find. However, before settling with a lender, we recommend you consult with various mortgage and financial institutions as programs and pricing vary tremendously.

This can be a very tedious and time consuming process. That's why we recommend working with X2 Mortgage as we're a Construction Loan Broker and we do that process for you. Not only will X2 advise you on the best construction loan for your financial situation, but also get you the best wholesale pricing.

Final Thoughts

It is true that construction loans have higher interest rates than regular mortgages. However, it is only about one percentage point higher than traditional mortgage rates. Also, factors such as your credit score and down payment can help you tremendously when it comes to obtaining a lower interest rate.

When you also consider the peculiarity of a construction loan and how it helps achieve your dream home or office, you'll know it's worth the rate. Aside from providing you with the funds to build your home, a construction loan can aid in properly planning, monitoring, and completing your building project.

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