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:
- First, generally learn about lot loans, land loans and construction loans so you can decide what type you need.
- Not quite ready to build? Explore Lot and Land Loans in more detail so you can buy a homesite before building, and learn how these loans are different from other real estate loans.
- Also find out why banks treat land and lot loans differently.
Be Prepared When Seeking 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]
- Construction, Lot & Land Loans: What Type of Loan do you Need? — lotnetwork.com
- Land & Lot Loans: The Dirt on Financing Your Property Purchase — lotnetwork.com
- Why do Banks Treat Lot and Land Loans Differently? — lotnetwork.com
- 8 Tips for Buying Residential Lots & Land for a New Home — lotnetwork.com