If you want to have a custom home built from scratch, you can take out a construction loan to finance the project. You’ll have to meet stringent lender guidelines and then convert the loan to a mortgage once your new home is built.
How a Construction Loan Works
A construction loan can cover several expenses associated with a home-building project, including the purchase of land and the cost of materials, labor and permits. A construction loan is only in effect while a house is being built and usually has a term of up to one year.
While your new home is being constructed, you’ll typically only have to pay interest on the loan. Construction loans usually have variable interest rates.
With a traditional mortgage, funds are disbursed all at once. With a construction loan, however, money is given out in phases. As construction progresses, an inspector or appraiser will have to make sure that the work meets requirements. If it does, the lender will pay the builder for that portion of the project.
After construction is finished, you’ll receive a certificate of occupancy. You’ll then have to take out a mortgage with a longer term, such as 15 or 30 years, and begin making payments that cover both principal and interest. You can choose a loan with a fixed or variable interest rate.
Loan Options After Construction Is Complete
If you take out a construction-to-permanent loan, it will automatically convert to a longer-term mortgage after contractors finish their work. You’ll only have to pay one set of closing costs.
With a construction-only loan, you’ll have to either pay off the balance after the house is built or take out a permanent mortgage to pay off the construction loan. If you take out a separate mortgage after the house is built, you’ll have to pay closing costs twice. That can add several thousand dollars to the overall price tag.
How to Qualify for a Construction Loan
A lender will have to approve of the builder you choose. You’ll be required to submit detailed construction plans and a budget for the lender to consider when reviewing your loan application.
You’ll have to meet strict requirements to obtain a construction loan. When a buyer takes out a mortgage to buy an existing home, the property serves as collateral. When a house hasn’t been built yet, issuing a loan is riskier for the lender due to the lack of collateral. That’s why construction loans generally require down payments of at least 20% and have higher interest rates than conventional mortgages.
Qualification requirements and loan terms can vary significantly from one lender to another. Before you take out any type of loan, request quotes from several lenders so you can get the best terms available.
