Are you planning on building a new home or renovating an existing property? Did you know a construction loan can help you finance your project and make your dream home a reality? Construction loans offer a flexible and affordable financing option for large-scale construction projects, but they can be complex and confusing. So, how does a new construction loan work? Here we have created a step-by-step guide to help you understand the process and how to obtain one for your project. We’ll walk you through acquiring and utilizing a construction loan. This guide will give you everything you need to know about how a new construction loan works, from preparing for the loan to paying it off.
What Is a Construction Loan?
A construction loan is a short-term financing loan that can help fund the construction of a new home or the improvement of an existing one. Similar to an installment loan, a construction loan is typically used for larger residential projects and has stricter guidelines regarding how much money you can borrow and for how long.
Unlike conventional loans, construction loans have shorter terms. For example, most conventional loans extend up to 30 years, with the option to select a shorter term, such as 15 or 20 years, depending on the lending institution (i.e., the bank). A construction loan typically has a loan term of one year or less. This form of short-term financing is quite specific to its purpose, which is to build or refinance a residential property.
Why Get a Construction Loan?
There are several reasons prospective homebuyers might consider a construction loan. Generally speaking, construction loans are used to cover the costs associated with building a new home, but this can involve several aspects, including:
- The cost of the land
- Contractors and labor workforce
- Building materials
- Land and building permits
Types of Construction Loans
Given that construction loans can be used for several purposes, it only makes sense that there are a few different kinds from which borrowers may choose. The three main types of construction loans are:
- Construction-to-permanent loans. Also known as a single-close loan, this type of new construction loan involves borrowing money to pay for the build of the home itself. It is rather straightforward in that manner. Once the homeowner moves into the residence, the loan automatically converts into the permanent mortgage. This type of new construction loan is best for people with construction plans that are set in stone and unlikely to change.
- Stand-alone construction loans. The name of the loan is what it implies – a single loan that finances the new construction. In this scenario, one would have a two-close loan closing process. The first loan used for the construction costs, and the second is a loan to pay off the debt accrued from the construction.
- Renovation construction loans. This final type of construction loan is one which can be used for “fixer-upper” types of houses. These can be used when purchasing a home, or to refinance an existing mortgage and add the costs of the renovations to the loan.
How Do Construction Loans Work?
The logistics of construction loans typically follow a set process.
Step 1: Applying for the loan. The prospective homebuyer will submit their financial statements, plans, expected project timelines, and other relevant information to the new construction lending institution.
Step 2: The lending institution will review the application and determine whether the applicant meets the necessary requirements to be approved for the loan. This depends on several criteria, including a minimum credit score (typically 620 or higher), licensed contractor on board, detailed construction plan, appraisal of the future home, and ability to pay the required down payment.
Step 3: If approved, the borrower may start using the funds provided to finance their construction project. Home inspectors may continue to assess the construction throughout the process if the borrower and builder requests additional funding.
Step 4: Upon completion of the construction project, the borrower must repay the loan with interest. It is also common to convert the construction loan into a permanent mortgage, at which point the borrower will repay both the principal and the interest.
Applying for a New Construction Loan
Before applying for a construction loan, there are several prerequisites you’ll need to meet. These include a good credit score, a steady income, and a down payment. You’ll also need to choose the right lender and obtain pre-approval, which involves providing information about your income, credit score, and other financial details. Pre-approval is important because it helps you determine how much you can borrow and what type of loan program is right for you.
This may involve providing documentation about the project, such as architectural plans and a construction timeline, as well as information about your income, assets, and debts. You’ll also need to select the right loan program, which will determine the interest rate and repayment terms. The loan will be disbursed in stages as the construction progresses, and you’ll need to manage the funds carefully to ensure enough money to complete the project.
Once the construction is complete, it’s time to start paying off your loan. This involves repaying the principal and interest on the loan, which can be done in several ways.
If you are considering building your own home or undertaking a major renovation project for a new home, it may be worthwhile to explore new construction loans. Find out more about how new construction loans work and how to get started with yours when you contact us at HomeLander Mortgage today!
