Construction loans differ from typical home loans. With a traditional home loan, you make a down payment, take possession of the home, and then make a payment to the lender each month. With a construction loan, you are asking the bank to estimate the value of something that does not yet exist—and then lend you money for it. A lot can happen during the typical 12-month construction process—from the expected construction delays and cost overruns to the unexpected—like a change in your employment situation or your builder going out of business. The risk to the bank is much greater, so it exercises greater caution in loan decisions.
A construction loan is really a reimbursement process. The bank does not advance construction funds; it will only pay for construction items that are complete. Each month you must submit a draw request along with supporting documentation to prove that building is progressing. The bank reviews the documentation, a third-party inspector visits the building site, and only then will the bank issue a reimbursement payment for the construction phases that are complete.
There are three major elements to qualify for a construction loan: the construction budget, including all the costs associated with building a new home; the appraisal value, or the estimated value of the new home when completed; and finally, the construction loan amount, including land equity and your down payment. Your personal financial qualifications determine this amount.
1. A straight, short-term construction loan, which does not automatically convert to permanent financing. The drawback to this is when construction is complete, you must pay another set of closing costs. And interest rates could be higher at that time.
2. A construction-to-permanent financing loan. This type of loan gives you money to buy the land and build the house. As the house is completed, the loan rolls into permanent financing. The construction-to-permanent loan is a multiple advance loan.
You need to set your project budget before you begin seeking a builder or settling on a house plan. You do this by pre-qualifying, a fairly simple step in the mortgage process. Pre-qualifying can be done in person or over the phone and is provided as a free service by most banks and mortgage companies.
Lenders want you to have more equity in the new home construction project, greater down payments, or land equity. Construction lenders want to see full documentation and asset-based qualifications. Your employment, credit scores, debt-to-income ratio, and other qualifications will be reviewed. With a maximum debt-to-income ratio of 38 percent, including both the payment on your current home and future loan payments, many homeowners will have to sell their current home in order to qualify for a construction loan.
1. Land—If you are buying land or if you own a building lot you need to consider the purchase price or land payoff costs in your new construction budget. Land improvements like water, sewer, grading, and utilities should be included in your construction budget.
2. Soft Costs—You will need home plans, site plans, permits, engineering, and other soft cost items. These expenses are often overlooked as part of the construction budget, as you will probably have to pay for them prior to closing on your construction loan. Construction lenders will want to verify that your house plans are complete and have been approved by your local building department.
3. Hard Costs—These are the typical costs used in per square foot cost breakdowns, and they include site work, excavation, building materials, labor, and general contractor fees. Your contractor may give you a fixed price contract for these items. Homeowners and builders tend to focus only on these costs when they are developing their budgets, mistakenly overlooking the soft costs and land development expenses.
4. Reserves—Most construction lending programs require you to have a reserve fund. Your contingency fund should be 5 to 10 percent of your total hard and soft costs. This amount should be added to your final construction budget, to be used for unplanned cost overruns. The contingency fund gives both you and the lender some security for unforeseen expenses. Many lenders also want an interest or cash reserve. The cash reserve can vary, but most programs will require you to have at least an additional six months of principle and interest payments in cash reserves.
5. Loan Closing Costs—Every loan will have fees that will be charged to the borrower: appraisal fees, title fees, underwriting fees, origination fees (points), and construction loan administration fees, to name a few. The lender will produce a Good Faith Estimate (GFE) to disclose all the fees and costs to you. They can add up to as much as 4 percent of the loan amount.
Your plans and specifications, like those for the Best Selling House Plans shown in the collage above, will need to be reviewed by an independent appraiser who will calculate the value of your building lot and completed home and compare it to recently sold and comparable homes in the area. The construction lender must verify that the completed home value will conform to the local market.
If you're hesitating to buy a house plan because you're not sure how big or small of a construction loan you're going to need, consider purchasing a Cost to Build Report for one or more home plans that you're interested in. This is a good way to get a much better understanding of the costs involved with a particular house design. You can purchase a Cost to Build Report from any house plan product page--just look for the blue Calculate Cost to Build button on the right side of the page. You can also take a look at our Cost to Build Frequently Asked Questions Page.