Building a home is an exciting opportunity to personalise your new space. But just like buying a house, construction can be an expensive prospect. Luckily, construction loans provide the funds necessary to buy land and pay for the materials and labour that go into building a new house. That said, there are several types of construction loans to choose from. Moreover, the application and approval process is more complex than for a traditional mortgage. Let’s look at everything you need to know about construction loans and the available types of financing and that you’ll need to qualify.
Everything you need to know about construction loans
What is a construction loan?
A construction loan is short-term financing that can be used to cover the costs associated with building a house from start to finish. Construction loans may cover the costs of buying land, drafting plans, taking out permits and paying for labour and materials. You can also use a construction loan to access contingency reserves if your project is more expensive than you planned.
How do construction loans work?
Construction loans let future homeowners borrow money to purchase materials and pay for the labour necessary to build a home. Often, this money also can be used to purchase the land you’re building on. However, if you already own the land, you may be able to use the property as collateral for your loan. Because construction loans generally are intended to cover the building process, they’re typically issued for a period of 12 to 18 months. That said, some loans automatically convert into a permanent mortgage once construction is complete.
Unlike traditional mortgages, construction loans aren’t secured by a completed house. For that reason, the application and approval processes for a construction loan also are more complex than for a mortgage. Your lender likely will want to inspect your architectural plans and examine your financial situation before approving you for financing. Your lender will also ask to see an estimated construction timeline and budget.
Types of construction loans
Building a home is not a one-size-fits-all process. To meet the varying needs of future homeowners, there are several types of construction loans available.
This loan finances construction of a home and then converts into a fixed-rate mortgage once the home is completed. Homeowners who want to save on closing costs and lock in mortgage financing. These types of loans can be much more expensive than traditional mortgages, so if you decide to go in this direction, shop around, compare rates and find the best deal before you pull the trigger.
This type of loan is short-term and is usually issued for a year. It’s meant to cover only the actual construction period. With so many variables like the builder’s cooperation, getting approvals from local municipalities and more, these are considered higher-risk loans. This means they’re harder to qualify for, and the interest rate will likely be higher than a traditional loan. In addition, if you decide to go this route, you’ll have to pay a second set of loan fees when you apply for a traditional mortgage.
Most akin to a traditional mortgage, renovation loans cover the cost of purchasing a home and performing major renovations. Because of this, the loan amount is based on the anticipated value of the home after renovations. Homeowners who are buying a fixer-upper intend to invest in extensive renovations.
Construction loan requirements
Before you can get the financing necessary to start your construction project, you’ll need to get approved for a loan. This process is typically more rigorous than for mortgages and other loans because the loan won’t be secured. In addition to imposing traditional borrower standards, lenders also will need to review and approve architectural plans, an estimated construction timeline and a proposed budget.
Good to excellent credit
To reduce their risk, lenders require borrowers to have a good credit score to qualify for a construction loan. If you’re planning to build a house, consider taking some time to improve your credit score before applying for a construction loan.
Enough income to pay off the loan
In addition to having a strong credit history, you should have enough income to cover payments on your current debts and the new construction loan. To confirm this, your lender will ask for financial statements or other documentation demonstrating your annual income.
A low debt-to-income ratio
A borrower’s debt-to-income (DTI) ratio is a comparison of all of your monthly debt payments to your gross monthly income. The lower your DTI, the more cash you theoretically have to make construction loan payments each month. To increase the likelihood that borrowers will be able to make payments, lenders typically require a DTI ratio of no higher than 45% when issuing construction loans.
A down payment of at least 20%
Borrowers are usually required to make a down payment of at least 20% when taking out a construction loan. However, many lenders require more – between 25% and 30% of the total construction costs. The requirement varies by lender, but if you make a down payment of less than 20% you may have to pay private mortgage insurance.
Project and construction budget approval
Because of the uncertainties involved in building a house, lenders want to see as much detail about the proposed project as possible. Improve your chances of approval by providing documents like a deed (or purchase offer) for the land, complete blueprints and specifications, a detailed line-item budget in the bank’s preferred format, a payment (draw) schedule, and a signed construction contract with change order provisions.
Builder or general contractor approval
Likewise, you’ll need to demonstrate to the lender that your architect and builder are qualified, licensed and insured. This may involve providing copies of the builder’s insurance certificates, resume and proof of financial stability. You also should include a description of each party’s responsibilities, including for the architect, general contractor and anyone else involved in the project.