Thinking about constructing your own home? Read this guide for all you need to know about home building loans.
How to Get a Home Building Loan?
They say that if you cannot find your dream home, build one! Yet, the truth is that constructing a home from scratch takes a lot of financial commitment. In fact, last year, people spent almost $436,700 on home construction.
To facilitate homeownership for everyone, the government has introduced multiple loans, which for years have helped millions of people realize their dreams.
In this article, I will talk about the ins and outs of home construction loans, their types, and eligibility criteria. Additionally, I will also give you a step-by-step breakdown so that you can go about the application and approval process with ease.
What is a Home Construction Loan?
A home construction loan is a specialized form of financing designed to facilitate the construction of a new home. They are tailored to meet the individual needs and financial circumstances of anyone who is undertaking new construction projects.
Unlike traditional mortgages, which are used to purchase existing homes, construction loans provide funds to cover the costs associated with building a new residence from the ground up.
How Do Construction Loans Work?
Now that you know what construction loans are, let’s quickly review how they work.
The loan works by providing funds in stages to cover the various expenses incurred during the construction of a new home.
Typically, it is divided into several disbursements, or “draws”, which are released as construction milestones are reached.
These milestones may include pouring the foundation, completing the framing, installing utilities, and finishing interior work.
During the construction phase, you are usually liable to make interest-only payments on the amount disbursed, rather than paying down the principal.
Once the construction is complete, the loan may be converted into a permanent mortgage or refinanced. At this point, you begin making regular payments toward both the principal and interest, as with a standard mortgage.
Construction loans are typically short-term, ranging from six months to a few years, and are tailored to the specific needs of the construction project. They provide flexibility and financial support throughout the building process, allowing borrowers to pay for materials and labor as needed.
What are the Types of Construction Loans?
Here are the seven main types of construction loans.
Conventional Construction Loan
This is a traditional loan offered by banks or mortgage lenders and is not backed by any government agency. They typically require higher credit scores and larger down payments compared to government-backed loans.
FHA Construction Loan
FHA loans are insured by the Federal Housing Administration. They are an attractive option for people with lower credit scores or smaller down payments because of their relatively lenient qualification criteria and lower interest rates than conventional loans.
Can you use a FHA loan for building a home? Yes, you can! FHA loans, which are insured by the Federal Housing Administration, are available for purchasing both existing homes and new construction.
VA Construction Loan
VA construction loans are guaranteed by the Department of Veterans Affairs and are available exclusively to eligible veterans, active-duty service members, and certain spouses. These VA home building loans offer many distinct favorable terms, including no down payment requirement and competitive interest rates.
Can you build a home with a VA loan? Yes, veterans and active-duty service members can use a VA construction loan to build a single-family home. The U.S. Department of Veterans Affairs (VA) backs loans provided by private lenders to eligible borrowers. VA construction loans are a beneficial option because they typically don’t require a down payment or mortgage insurance and have more lenient credit requirements compared to traditional construction loans.
USDA Construction Loan
USDA loans are designed to promote rural development and homeownership in eligible rural areas. To facilitate qualified individuals, these programs offer low-interest financing and may require no down payment on USDA home building loans.
Construction to Permanent Loan
Also known as a ‘single-close’ or ‘one-time close’ loan, this type of loan combines construction financing and permanent mortgage into a single loan, which simplifies the process for borrowers. The construction to permanent loan process is a very important stage for a borrower building a home in 2024. Once construction is complete, the loan automatically converts to a traditional mortgage.
Renovation Construction Loan
These loans are specifically tailored for homebuyers looking to purchase a fixer-upper or renovate an existing property. Funds are allocated not only for construction but also for renovation costs.
Owner-Builder Construction Loan
This type of loan is suitable for individuals who plan to act as their own general contractor or oversee the construction process themselves. Owner-builder loans provide financing for materials and labor, allowing borrowers to save on construction costs.
What are the Home Building Loan Requirements?
Each type of construction loan has its own requirements. However, there are some general factors demanded by almost all programs offering a home building loan.
High Credit Score
A credit score signifies your financial reliability and trustworthiness, which is why a commendable credit score is one of the most important requirements of construction loans.
Typically, if you go for conventional loans, you would need a score of around 700. However, various programs like FHA loans, USDA, and VA loans are more flexible in this regard.
Down Payment
From a lender’s standpoint, a substantial down payment is fundamental in mitigating risks, because it reassures them of your capacity to manage debt responsibly.
While conventional mortgages typically require only a 5% down payment, you need to put at least 20% for construction loans.
However, this varies for each type of loan. For example, FHA loans accept a significantly lower 3.5% down payment, whereas VA and USDA don’t need any investment.
Detailed Construction Plan
Sharing a detailed construction plan with the lender is important to secure a construction loan. You should have an elaborate plan including the timeline and cost breakdown, Additionally, it should also outline materials, building specifications, and zoning compliance details.
Lenders use this information to judge the project’s viability, so you need a great plan for successful home construction execution.
A Reputable Builder
The skills of a builder determine how well your construction project turns out. Their expertise, track record, and reliability reassure lenders, which is why you need to have a reputable builder on board to get loan approval.
Appraisal
A thorough appraisal process, evaluating the location, condition, and market trends is vital for loan eligibility. It provides an accurate assessment of your property’s worth, helping ensure that the value aligns with the loan amount.
How to Get a Construction Loan?
Now that you know how construction loan works, and what the eligibility criteria are, here’s a step-by-step guide on how you can apply for and get the loan:
Research Lenders
First of all, research lenders who specialize in construction loans. Look for institutions with experience in this niche area, as they understand the unique requirements and complexities involved.
Check Eligibility
Evaluate your eligibility for a construction loan. As I mentioned before, lenders typically look for factors such as a solid credit score, sufficient income, and a detailed construction plan. Make sure that you meet these criteria before proceeding further.
Prepare Documentation
Gather the necessary documentation required by lenders. This typically includes proof of income, tax returns, credit reports, construction plans, and permits. Remember that the application process is often lengthy, and having these documents ready in advance streamlines it.
Meet Down Payment Requirements
Be prepared to make a substantial down payment, usually around 20% of the total project cost. Some government-backed loans may offer lower down payment options, but you need to check if you qualify for them.
Select a Builder
Choose a reputable builder with a track record of successful projects. Lenders often demand that you work with approved builders to ensure the quality and timely completion of the construction.
Undergo Appraisal
The property will undergo a thorough appraisal to assess its value. This appraisal helps determine the loan amount and ensures that the property serves as adequate collateral for the loan.
Submit Construction Loan Application
Once you have all the necessary documentation and have selected a builder, submit your loan application to the lender. Be prepared for a detailed review process, including credit checks, income verification, and assessment of the construction plans.
Review Loan Terms
Carefully review the terms and conditions of the loan, including interest rates, repayment schedule, and any fees associated with the loan. Seek clarification on any aspects that are unclear before proceeding.
Close the Construction Loan
Once the loan is approved, you’ll proceed to the closing stage. During this process, you’ll sign the necessary paperwork and finalize the loan agreement.
Start Construction
With the loan secured, you can now commence construction on your project. Remember to maintain open communication with your builder and lender throughout the construction process to ensure everything progresses smoothly.
Final Words on Home Building and Construction Loans
Despite the raging costs, building your own house is now possible with home builder loans. From conventional to government-backed loans, there are multiple options available that you can choose from.
Make sure to carefully follow the steps outlined in the article, choose the best homebuilding lenders, and you can become a homeowner in your dream place in no time.
Whether you’re considering a construction loan, a home improvement loan, or a home equity line of credit, borrowing money for your next home project offers a variety of options. It’s important to determine the best loan type for your specific needs and compare rates to find the best deal.
If you’re planning to remodel your current home but feel that a renovation loan isn’t the right fit, or you need permanent financing after completing construction, the lending experts at BD Nationwide offer home building loans designed to help you reach your goals.
Frequently Asked Questions on Construction Loans
What credit score is required to build a house?
Credit score: At least 580, or as low as 500 if you’re making a down payment of at least 10%.
Debt-to-income ratio (DTI): Typically no more than 43% (though exceptions may apply). Down payment: 3.5% with a credit score of 580 or higher, or at least 10% with a credit score between 500 and 579.
What costs are covered by a construction loan?
While the exact terms depend on your lender, construction loans typically cover all the costs associated with building and renovating a property. These costs may include purchasing land, labor, materials, permits, and fees.
However, it is essential to mention that designing is not covered by a lender, and you need to pay out of pocket if you are hiring a qualified architect.
How to draw money from construction loans?
To draw funds from a construction loan, you need to submit draw requests to the lender at each stage of the project. Your lender will then inspect the progress, verify the expenses, and disburse funds accordingly.
What closing costs to expect with a home building loan?
Similar to a traditional mortgage, closing costs for construction loans vary depending on the exact terms of your loan, but they normally range from 2% to 5% of the total price of your home construction project. This means that if your new home will cost $200,000, then you can expect to pay $4,000 to $10,000 in total closing costs.
What are construction loan rates?
Construction loan interest rates are generally higher than those of traditional mortgages, typically ranging from 5–10% APR, with an average of about 1% higher. Interest rates can vary depending on factors such as the borrower’s credit scores, the loan term, and the loan amount. These construction loan rates are often variable, meaning they can change during the loan term based on an index, such as the prime interest rate.
