If you’re building a new home, you may need some help when it comes to financing. This is because you can’t take out a conventional mortgage without a house to live in. This is where a home construction loan can come in handy.
Home construction loans provide temporary financing that can help you fund the various costs of building a new home. When your home is complete and habitable, you will have to refinance your construction loan into a standard permanent mortgage.
Most people find it hard to pay upfront for the cost of a new residential or commercial project. Hence, the process of getting a home construction loan usually begins with a lender, such as a local credit union or regional bank.
However, keep in mind that unlike a traditional loans, construction loans are more difficult to secure because you are requesting to borrow funds for a new home that does not exist yet.
Construction Loan: What You Will Need
Home construction loans, in particular for large or costly building projects, often require extensive vetting and pre-planning. This increases your chances of securing the funds you require. In most cases, you will have to fulfill all of the following requirements to assure your prospective lender that you have your ducks in a row before the construction commences.
Your Ability to Pay off the Loan
There are various factors that your lender will consider when deciding your application for a home construction loan. The first, and perhaps the most important, is your ability to repay the loan. Money is disbursed during the construction phase in “draws,” which are mainly based on the stage of project completion at specific intervals.
In many cases, borrowers are required to set aside a specific sum of money known as an interest reserve. Borrowers make monthly payments from this account until the construction project is complete.
As a borrower, you will need to show that you would be able to pay off the loan once the lender disburses the full amount. Your lender will like to see proof of income as well as the amount of any other outstanding debt.
A Qualified Builder
To get a lender, such as a bank, to fund your new home building project, you have to hire a reputable, experienced and licensed builder along with suitable documentation to prove it. Therefore, unless you plan to build the house without a professional and reputable builder (which may require another type of loan), you will have to furnish a list of your prospective builder’s projects, both past and present.
Also, keep in mind that many lenders may also request you to provide a comprehensive profit and loss report. Finding a bank or credit union to fund your building project will prove exceedingly difficult if you plan to build your house on your own or hire an amateur builder.
Note that the criteria for home construction loans are based, to some extent, on the value of your completed product. Therefore, getting an appraisal is one of the important requirements for a home construction loan. Usually, a licensed appraiser estimates the home value.
An appraisal determines the value of your home once it’s complete. The appraiser may carry out a loan-to-value calculation to ensure the value of the property covers the amount of the loan. This step helps protect the bank's interests in case you fail to repay the loan. The appraiser is also responsible for considering the details in the blue book.
Details of the Construction Plan
No scrupulous bank or financial institution would hand over a considerable sum of money without a clear plan. This is why delineating a detailed construction plan is one of the vital requirements for any construction loan.
Therefore, to maintain a productive relationship with the lender, you have to furnish a detailed description of all aspects of your construction plan. These details should include pertinent information regarding the general timeline of your project. This information can include ceiling heights, floor plans, and the type of home insulation you will use. Moreover, you can include the costs of building supplies used in the structure.
In addition, you will have to provide reasonable profit projections for the future of your house as well as an inventory of the building materials. The project blue book should also mention all the subcontractors and suppliers involved in the project.
Lenders may also consider your credit score and, at times, cash reserves. In most cases, credit score requirements tend to vary depending on the size of the construction loan. If you are applying for a higher loan amount, you will need a higher credit score. A majority of lenders would prefer to see a healthy cash reserve. You should have reserves to cover at least 6 months of PITI (payment, interest, taxes and insurance).
A sizable down payment is another requirement for a home construction loan. Home construction loans often provide a considerable amount of money for ambitious projects. Thus, it is not surprising that most lenders often require at least 20% down payment. Some lenders may even ask for up to 25% down payment.
They state this rather high minimum amount to ensure that you and your homebuilder invest sincerely in the construction project.
It is understandable that lenders do not want borrowers to abandon their construction projects should things get a little difficult down the line.
Obtaining a home construction loan is likely to be a challenging pursuit; however, it boils down to your passion and commitment to see your home building process through to its final stages. Understanding how home construction loans work mainly hinges on being fully aware of these important requirements.
So, make sure that you have a reputable and licensed construction company as well as description of your construction plan. Also, have the down payment money ready. Moreover, get an appraisal to increase your chances of securing a construction loan for your dream home.
About the Author
Brian Quigley has been in the Denver mortgage industry since 2003. Customer satisfaction has been his top priority while guiding clients through the home loan qualification process. He is proficient in all types of mortgage financing including FHA/VA, Conventional, USDA, Jumbo, Portfolio, 1031 Exchanges, Reverse Mortgages, Refinancing, Construction loans, and FHA 203K loans.