A Beginner’s Guide To Residential Construction Loans

A Beginner’s Guide To Residential Construction Loans

It can be frustrating to purchase a home. You will need to go through the available properties and choose the ones that appeal to you. Once you find the one that ticks all your boxes, it is Residential Construction Loans time to go through the offer process. The mortgage process will follow once your offer has been accepted.


You can also build your home. While you will still need to travel a long way to reach your dream home, custom homes offer you the chance to customize the home with the features that you desire.

This is not the only difference between new construction and buying an existing property. Loans are also completely different.

What is a Construction Loan?

You will need to look into more financing options if you are planning on hiring your own general contractor. A construction loan is a short-term loan that manages and disperses costs for custom-built homes. It typically lasts 12 to 18 month.

These costs may be covered by a construction loan:

  • Lots or land available for construction
  • Architectural plans
  • Permits
  • Labor
  • Materials
  • Contingency funds (if your project goes over budget)

What is the process of construction loans?

The application and approval process for a loan is more complicated because there is no existing property to be secured with the loan, unlike a traditional mortgage. The lender will likely request a review of your plans, budget, and description of materials.

Construction loans are different from traditional mortgages in that they do not pay out in one lump sum. Instead, construction loans work as a line-of credit. Based on the relationship between lender and builder, the lender might make payments directly to sub- and supplier or to the builder as the various stages of the project progress. Your lender may request that an inspector evaluate the progress of each payment before making any payments.

Kim Moore, Mountain America Credit Union’s assistant vice president for mortgage sales, stated that “most construction loans require you to only pay the interest as the funds are paid out.” After the project is completed, the loan can be converted into a permanent mortgage. If you want to repay the construction loan, you will need to qualify to get a new mortgage.

Different types of construction loans

There are many ways to build your new home. You can choose to demolish an existing home to build a new one or keep the bones to rebuild. You can choose from any of these options, or something else entirely. A construction loan will work for your needs.

Construction loans are available from different lenders so make sure you shop around to find the best deal for your needs. These are the most popular types of construction loans:

Construction-only loan – Considered a more risky loan, this loan can be used to cover construction costs. The loan must be refinanced or paid off in full once the project is completed. This loan type will require you to complete two separate applications and close at two different times. This loan type is best for borrowers with cash reserves or who intend to repay the construction loan through the sale of their home.

Construction-to-permanent loan–These loans also are short-term loans that cover the construction costs–but they convert automatically to a permanent fixed- or adjustable-rate traditional mortgage once the home is completed. You’ll only pay interest during construction. This is a great option for borrowers who wish to lock in mortgage financing and save money on closing costs.

Renovation loan – Similar to regular mortgages, renovation loans are insured under the Federal Housing Administration (FHA). They cover the purchase and construction of a home. Sometimes they are called 203(k), loans. This type of loan is typically chosen by homeowners who intend to buy a fixer upper and make major renovations. The bonus? The added bonus? Borrowers only need to pay one loan payment, even if they are buying and renovating.

Other options to finance a renovation are available that don’t fall under construction-specific loans. Moore suggests that homeowners with equity in their homes have access to home equity, line credit, and refinance options.

Owner-builder loan – If you have decided to be your own general contractor, then this loan could be a good option. You will need to prove your ability to supervise the construction project. This means you’ll need to have the proper licensing, education and experience.

A long-term loan Once construction is completed and final inspection has taken place, you can apply to for a loan. This is essentially a traditional mortgage. This may work for you if your construction loan cannot be converted to a traditional mortgage.

Construction loan requirements

As we have already mentioned, the process for getting a construction loan is more complicated than a traditional mortgage. Because the loan is shorter-term, and there is no home to guarantee the loan, the lender has a greater risk. More risk means more requirements.

These are some of the things that your bank or credit union will take into consideration during the approval process.

  • Credit score- Typically, good to excellent credit is required in order to obtain a construction loan of 680 or more. Some lenders may require a higher score, such as 720 or more. You can improve your credit score before you apply for a construction loan. Each of the three major credit bureaus offers a free credit report review.
  • Your lender will need to verify that you have sufficient income to cover the construction loan payments and all other financial obligations. They will need documentation to prove your annual income.
  • This is a comparison between all your monthly debt payments and your gross monthly income. The theory goes that the lower your DTI is, the more cash you will have to pay off the loan. Aim for a DTI below 45%.
  • Down payment –Lenders typically require a minimum of 20% down payment. Some lenders may require more. You may be able put down less than 20% but private mortgage insurance (PMI), will usually be added to your monthly payment. Compare all details before you shop around.
  • Plans and budget– The more information you give to your lender, the higher your chances of getting approved. As long as everything is in order. Your lender may request detailed plans and budgets for your project, as well as a payment schedule and builder qualifications (license, insurance certificate and proof of experience), and a signed construction contract.

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