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Construction Loans: Financing Your New Home from the Ground Up

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Home construction loans help you get from a vacant lot…into your dream home. So if you’re dreaming of building a new house from the ground up, you first need to understand construction loans. Home construction loans are not like most loans and in this article we describe how they work, typical loan terms and how these loans are different from other real estate loans.

Also read our other articles in this series on real estate loans for buying land and building homes:

Be Prepared When Seeking Construction Loans

Be Prepared When Applying for Construction Loans

Building a new home can be an exciting experience, and if you’re ready to start building your new home as soon as possible then a construction loan likely is what you need. But to apply for and close on this type of loan you first must be prepared, meaning you will need to complete some important design and planning work in advance.

As we have noted in other articles, construction loans are “story” loans – and unlike getting a purchase money loan to buy a specific already-built home, there can be a lot of uncertainty when the land is vacant and a home has not yet been built. Lenders want to understand who you are and what you intend to do with their money. Most lenders consider construction loans more desirable than vacant land loans, but each lender will have different policies, requirements and terms for processing and approving construction loans.

So before seeking a construction loan, be sure to get your financial matters in order like you would for any loan. It’s wise to have had some preliminary discussions with several banks so you can understand your borrowing capacity and be prequalified or preapproved for a loan.

And as further described in this article, you also need to do some other work and planning in advance related to building your house. Before moving forward on your construction loan, lenders will expect you to have already found and secured your homesite (search for lots and land here). In addition, you should have selected your final house plans and design for your new home and already contracted with a reputable home builder who will build the home for you.

 

Purpose of Construction Loans

The main purpose of construction loans is funding the construction of a new home, and a construction loan typically is obtained by a prospective homeowner when they are having a custom or semi-custom home built for them from the ground up. Lot loans and purchase money loans just provide the funds for buying an asset, but a construction loan acts like a line of credit that the borrower can use to draw down funds at intervals and keep the work progressing.

If you are buying a home from a production home builder (even if the new house has not yet been built) then you most likely will buy the home after it has been completed using a standard purchase money loan. And if you are buying an already-built home – whether it is pre-owned or a new “spec” home – you also typically would use a purchase money loan. Some use the term “end loan” to describe when a buyer uses a loan to purchase a new home after the builder has financed construction of the home.

New homes may be built on a lot or land that already is owned by the borrower, and in this case a construction loan primarily is used to fund the materials and labor for building the house. However, a borrower also can use funds from a construction loan to purchase new property as the homesite,  whether the borrower is purchasing from a separate landowner or directly from their builder who may be both selling the lot and building a home for them (a “Turnkey” transaction). In this scenario, the closing for the construction loan would occur simultaneously with the closing for the purchase of your homesite, with the construction loan funds (and your down payment) being used to purchase the land.

When coordinating a lot purchase and a construction loan be sure to have the land securely under contract with a long enough time period until closing (or the right to extend the closing date) so that you can proceed with getting a construction loan approved and ready to fund.  Also, just in case you are unable to get approved for a construction loan, it is wise to include as a condition for closing in your lot purchase contract that you must be able to successfully secure a construction loan on acceptable terms. This should allow you to terminate the property purchase contract if you are unable to get your financing.

 

Construction Budgets for Construction Loans

Your lender will need to see a comprehensive construction budget so that it may evaluate and approve the funds that are needed to build the home. To do this, you will already have selected the lot and approved a final set of house plans and specifications for the proposed home. You also need to have a construction contract with your home builder.

The budget needs to be comprehensive, including all upgrades, appliances, landscaping and other items that you intend to fund with the construction loan. Because a borrower cannot increase the amount of the construction loan after it closes, a contingency amount or reserve often is included in the loan in case there are more expensive options selected or cost overruns after construction has begun. Be sure to include the cost of buying the lot in your budget – or if you previously purchased the homesite using a lot loan, be aware that the construction loan will be used to pay off the first loan.

 

Construction Draws, Schedules and Periodic Advances

The construction loan funding process is unique when compared to other loan types. Purchase money loans for existing homes and loans for buying lots and land simply are funded in full at a loan closing. In contrast, a construction loan borrower receives periodic loan advances – also known as “draws” – based on predesignated milestones being met in the construction of the home.

To plan for these periodic loan advances the borrower and its contractor will work with the lender up front to establish an approved draw schedule for the work. The loan draws will be funded when construction milestones have been met and will be used to pay the builder, subcontractors and suppliers what they are owed. Milestones and methods for scheduling draws can vary from lender to lender (and are described further below).

To initiate the funding of a draw under your construction loan, your builder will provide a draw request form and other documents to the lender that includes a report on progress, mechanics’ lien information and details for the requested funds. Job site inspections will be performed and reported back to the lender to confirm the amount of work that has been completed and that the work was done in a manner that meets the job’s specifications. The inspector will be an independent party, and in some cases may be an engineer or architect. The title company also will review the property records to make sure no mechanics’ liens or other problems have arisen. This process may seem like a lot of work, but it allows the lender to confirm that it is protected and that it is not funding more than the value of the partially-constructed home.

The first draw under a construction loan typically will cover closing costs and the purchase price of your lot.  Sometimes soft costs like house plan design fees, engineering costs and permits will be included in this first draw. The timing of subsequent draws can vary widely, but they may be triggered by a time period (like monthly), by the completion of construction phases (after grading and foundation work, then after framing and roofing, etc.) or on a calculation of the percentage of work that has been finished by the contractor for the overall project. The builder will need to show that the home has been completed to process the final draw, which usually can be done with a certificate of occupancy (or its equivalent) and final inspection by the lender.

Advances under a construction loan usually are not made directly to the borrower. Instead, the lender typically will fund the draws directly to the builder or others that need to be paid.

 

All-in-One Construction Loans

One of the most important things to understand about home construction loans is the availability of “Construction-to-Permanent” financing. This loan product – which also may be called an “All-in-One,” “Single Closing” or “Rollover” construction loan – has revolutionized the construction loan process and is the loan of choice for most construction loan borrowers.

This type of loan allows a borrower to work with one lender and have one loan closing because the borrower closes on a single loan that funds the home construction and then converts to a permanent loan after the construction has been completed. The conversion usually is triggered by the issuance of a certificate of occupancy (or its equivalent) and your lender’s final inspection and approval. The terms and details of the permanent loan will be agreed upon in advance and the final principal amount for the permanent loan will be based on the amount disbursed during the construction phase. Converted long-term loans can be either conforming or non-conforming (see more below).

Prior to the availability of Construction-to-Permanent loans, borrowers first had to get their construction funding via a short-term construction loan. After the home was completed, the borrower then would need to coordinate a second loan closing for “take out” permanent financing to pay off the construction loan. This process is inefficient because it requires two loan applications, fees from two loans, two closings and higher overall transaction costs for the borrower. The two loan process also is riskier for both the borrower and the construction loan lender because there always is a chance that the permanent financing cannot be found to pay off the short-term construction loan.

Banks still offer separate, short-term construction loan products that do not convert. There may be some benefits, like being able to shop around to find the best long-term financing deal, but most borrowers choose the convenience, savings and other benefits of Construction-to-Permanent financing.

[Click here for Part 2 of this article on Home Construction Loans]

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Discussion

  1. Chris says

    Hi Steve,
    I was wandering if there are any loans, similar to the construction loan, that are available for the renovation of an existing home, to include the purchase of the home even if it is being bought in “as-is” condition. The reason I’m asking is, I have several investors I do business with to flip houses with and I would love to start this process on my own without much capital of my own to lay out.

    • says

      Hi, Chris. There are home improvement and renovation loans that operate similar to home construction loans (draw schedules, inspections, etc.). But, like construction loans for new homes, these home improvement loans are targeted to owner-occupied borrowers. I think you’ll find it more difficult to get approved for one of these loan products for an investment/flip scenario.

      The availability of loans may change as the lending market continues to loosen up, but I still don’t see this type of option readily available today for investors. I hope you find a good resource for your renovation projects. Good luck!

  2. Michele says

    My husband and I own our lot of .68 acres in a subdivision. The lot is in the shape of a baseball field. How do we know if the home plan we have found will fit on this unique shaped lot? Do you know the max width and length of the home that would fit this baseball shape? The neighborhood has homes that are valued from $250,000 up to $500,000. Most of the homes are 2000 to 5000 sq ft homes. When we build does the cost of the home have to be in this price range? What will determine the value of our home? Also, we wanted to put 20% down for the construction to perm loan, do you have to have the whole 20% at the time of closing or can payments be made through the home build and the complete 20% be paid by the end of the home build. Also, if we purchase most of the items for the home ie appliances, doors, cabinets etc do these cost come off of the price of the home?

    • says

      Thanks for posting about your lot and your plans for your new home. This can be an exciting process…but sometimes stressful and complicated at the same time.

      I have to start by noting that it is difficult to provide specific feedback to some questions because each situation is so different. The “right” answer or action can depend on many things like your lot, your market, applicable government regulations, neighborhood rules, setbacks, property easements and various restrictions, among other factors.

      Depending on where you are in the process, I suggest that you talk to potential builders or even a surveyor to get some general insight about whether your chosen house plan will work on your lot. If it won’t fit properly, a builder can even give you suggestions about how the plans can be altered to make them work. Some residential designers also will work with and adjust existing house plans to meet your needs.

      If you think you are ready to move forward, get some price estimates from builders about the cost to build your home. The market will be what determines the value of your home. So even a grand home design may not match its value potential if it is located in a market that does not support that value; likewise, a more modest home may have a surprisingly high value when located in a desirable market. You can work with an appraiser and use your house plans to get a feel for the value of the completed home. Consider getting lending proposals too, so you can find out what you really will be able to borrow. And, yes, you do need to be prepared to put the 20% in either at the closing of the loan or during the initial stages of construction. The down payment can be done in a mixture of cash and equity that you have in your lot, but the bank will want you to have your money/equity in the transaction from the start (or, at least before the bank advances money under the loan). And if you wish to buy things outside of the loan (like doors, appliances, etc. as noted in your post), then that likely will just decrease the amount of loan funds that you need. But you’ll need to coordinate on this issue with both your builder and your bank, because in the end the lender will likely want to see that the home has been fully-completed and that the bank did not just fund the construction of a shell.

      Hope that helps. Best of luck in building your new home!

  3. Mark says

    We are planning on purchasing a lot in the next few months but will not be ready to start construction of our custom home until probably the first quarter of 2015. If we purchase the lot, then when we are ready to build, are there lenders that would refinance the lot along with the construction loan for the house? Or would we just need to seek a construction loan for the home?

    • says

      Hi, Mark. Good luck with your lot search and purchase. You’ve come to the right place to find lots for sale!

      As for your question about paying off the lot loan at the time of the construction loan, it all depends on the situation. But if you finance your lot purchase your construction lender will likely want you to pay off and refinance that loan. The construction lender will not want a senior loan outstanding that is secured by your property can supersede the construction loan. Hope this helps!

      • Mark says

        Thanks Steve. We would like to go ahead and purchase the lot. Then when ready to build, take out the loan to both pay off the lot & refinance it, and also the funds for the home construction.

        • says

          That should work. If you own your lot outright, the construction loan bank should not expect you to put more lot/equity value in the construction loan transaction than what you would need for your down payment on the loan. They should be willing to finance the balance of the lot’s price or value as part of the construction loan. If the bank is asking you to put in more than you prefer, then I would suggest that you try talking to other banks to compare terms. Good luck.

  4. says

    Steve, your articles on construction loans are informative. I now have the answers to my questions.

    In addition, thanks for the treasure trove of lots across the country!

  5. says

    Applying for the constuction laon for your home is best option if you have amount shortage. Go ahed for the home laons, Now many companies provides the facility of the home loans you can take the help of them.

  6. G says

    Hi Steve,
    We are working with a banker in an construction loan for $400k. We own the lot. His estimate has $4k Closing costs.
    Is this normal ?
    And will the closing cost cover the conventional loan too?
    Thanks

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