What to know about getting a construction loan

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If you are looking for the perfect property to build a home on, this can be an exciting time. Building a house is a completely different experience from buying a pre-existing house.

You get the customization of the house according to your tastes and personalize it.

You also go through a different loan process. A construction loan is what you would apply for instead of a traditional mortgage. The construction loan process and terms are different for a mortgage, and here are the things to know.

What is a construction loan?

Construction loans are short-term financing that only covers the cost of building a custom-built home. Construction loans are considered specialized financing, then once your home is built, you need to apply for a mortgage. This mortgage is what you use to pay for the completed home.

There are other loans available in addition to construction loans if you are planning to completely renovate a house.

A construction-only loan is usually short-term, issued for one year.

The construction loan only covers the actual construction period, and many lenders do not offer this type of financing.

Construction loans are considered high risk due to many variables, such as obtaining local municipal approvals, builder cooperation, and other factors.

The interest rate on a construction loan is often higher and harder to qualify for. You also have to pay a second set of loan fees when applying for a traditional mortgage later.

A permanent construction loan is something a custom builder can apply for. These loans finance the construction, then they convert it into a permanent mortgage. If you are the borrower during construction, you only make interest payments. This type of loan is expensive, so compare before accepting anything.

You may qualify for an owner-builder loan if you act as your own general contractor, but this is not common. The lender will ask you to show that you have the necessary experience, education and licenses to build the home.

When you have a construction loan, the lender pays a contractor in installments as certain stages of the project are completed.

What is covered?

While every project is unique, a construction loan will typically pay for land, plans, permits, and fees. These loans can also pay for labor and materials, closing costs, contingencies, and interest reserves.

How it works?

If you are borrowing money to build a custom home, it may be more difficult to qualify because there is no collateral securing the loan like there is with a mortgage. With a traditional mortgage, the house is the collateral.

This means that you will have to go through additional steps in regards to the lender.

The lender will thoroughly inspect the plans and your finances.

The disbursement of this type of loan, as mentioned, is paid to the builder in installments called drawdowns.

Each print corresponds to a part of the project. For example, there may be a draw after the foundation is poured and the house is framed. Then there may be another when the finishing work is completed.

An inspection is usually required before each drawing is released to the builder. The payment amount is based on the work performed by the builder, which is noted in the inspection report.

Mortgages are transactions between a borrower and a lender – with a construction loan, a third party is involved, the builder.

Your contractor needs to be able to complete the build on time and on budget, so choose someone carefully.

You should review the builder’s references and other work they have done. Make sure your local building authority approves their plans.

The lender may also request a work history for the builder, plans, proof of insurance, a list of materials, a detailed budget, and a signed construction contract with a start and end date.

What about the down payment?

Finally, a deposit of 20 to 30% may be required for a new construction.

As with other mortgages, the minimum credit score, maximum debt-to-income ratio and down payment will vary depending on the lender and your personal circumstances.

In most cases, like a traditional mortgage, your down payment is based on the amount you borrow.

Construction loans are tricky and may not always be the best option, but at the same time, if you want to build a custom home, they may be your only option.

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