Construction Loans—What you Should Know

With a construction loan, they will cover the cost of the land, permits, building materials, and the contractor and labor.  They can also include covering permanent fixtures like landscaping or appliances but not home furnishings.  Make sure when discussing your loan, ask what will be specifically included in the loan-to-value calculation.  Sometimes they will also include a contingency reserve.  This can be used to cover costs that were unexpected during the construction process.  It is also a cushion in case the one borrowing the money decides that they want to make some upgrades during the construction process.  For example, they may want to upgrade their cabinets or countertops.

To get a construction loan, you will need a low debt-to-income ratio, a good credit score, and proof that you have enough income to repay the loan.  You will also need to make a down payment but how much will depend on the lender where you are getting the loan.  It will also depend on how much you are requesting to borrow.  On average, it is 20-25%.  

You will also need to have a detailed floor plan and the type of materials you are going to use.  Having a property report can also help.  This type of report will tell the lender the boundaries of the lot you are building your home on, any owners who are on the title and their phone numbers, and other vital information.

Before you apply for a loan, talk to your contractor to discuss the timeline of building your new home and if there are any possible issues that could slow down the job.  When you apply for a construction loan, the lender will want to know the approximate timeline to finish the build.  Also, this type of loan is generally for one year and then it has to be paid off.  It is considered a short-term loan.  With a construction loan, it is not secured by any assets so there are generally higher interest rates.  The reason is that this is a riskier type of loan for the lender to approve.  

This loan will come with an adjustable or fixed interest rate and are like a credit card.  There is a line of credit that you draw on throughout the construction process until the house is finished.  One plus with a construction loan is that you will only pay interest on what you have borrowed that month when you make your payment.

The builder will set up a draw schedule and the funds will either be paid to the builder or you so you can pay them.  Many times, the lender will require an inspection of the property to make sure that work is being done on the construction process before they release any money.

Conclusion

With a construction loan, what it pays for is very limited and it is short-term, usually one year, and then has to be paid back in full.  Then you will need to apply for a mortgage for the rest of what you need for the home.