If you plan to build your next home, financing it will be a different process than securing a standard mortgage. You will need to apply for a home construction loan, often called a “construction-to-permanent” or a “single-close” construction loan. This versatile type of loan will pay for construction costs in stages and then convert into a traditional mortgage once you receive a certificate of occupancy to move into your new home.
A home construction loan is used to cover the labor and material expenses for new-build homes. The loan will pay for costs associated with permits, contractor labor, home and roof framing, interior finishing, landscaping, and many of the other expenses involved in building a house. The lender, a bank or credit union, pays out the money in stages as construction milestones are reached. Money is paid directly to the builder, and borrowers are usually only required to pay interest on the total amount of funds paid out to date, until construction is complete and the loan converts to a traditional amortized mortgage loan.
Typically, a construction loan has a variable interest rate that can fluctuate and can start a little higher than the final rate when it converts to a traditional mortgage. The reason for this is because a construction loan is a higher risk for the lender—with a traditional mortgage, your home acts as collateral and the lender can seize the home if you default on payments. But with an in-construction house, the bank doesn’t have that value-secure collateral to offset its risk of lending to you.
Getting a home construction loan
Unlike with buying an already-built home—where you should always meet with a lender before looking at homes!—with a home construction loan, you’ll want to work with an architect and/or builder first, have plans and specifications drawn, and negotiate a contract listing the total cost to build. With that done, you’ll know what size loan you’ll need!
A lender will typically ask to see a construction timetable, detailed plans, a realistic budget, and a draw schedule for when the builder expects construction funds to be paid out. Your lender may also ask to see the builder’s work history, proof of insurance, and a materials list. All of this helps assure them that you’re working with a reputable builder who knows what they are doing and has realistic budget expectations, which all makes them less of a risk.
Next, the lender will look at your loan eligibility and risk level. You will provide all of the same documents and materials that you would for a traditional mortgage: tax returns, bank statements, and pay statements or stubs. In addition to income stability, lenders will want to see a minimum credit score, a maximum debt-to-income ratio, a cash cushion for over expenditures, a low debt-to-income ratio, and a 20 to 30 percent down payment. These numbers will vary from lender to lender.
If you already own the land you’re building on, you can use its value as equity and a part of your down payment. Lenders may want to conduct their own property appraisal to confirm its value if used as collateral, i.e. part of the down payment.
Once you are approved for a home construction loan, you will be put on the draw schedule (sometimes called a “bank draft” schedule) that matches the house construction stages; however, the funds will be requested by the builder and paid to them. You will only be required to pay the interest payments on the total drawn during construction. As funds are requested, your lender will send someone to review the project’s progress.
Time to move in
Your home is built! The paint has dried, the landscaping is fresh and green, and you’re ready to move in. Once you have obtained a certificate of occupancy from your local government agency, your lender will transform your home construction loan into a traditional mortgage, and you will begin making full monthly payments.