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Construction Loans for Your Dream Home

By Arvin Sahakian · May 29, 2015 · Mortgage

Construction Loans for Your Dream Home

Image courtesy of Flickr, U.S. Army Corps of Engineers

Construction loans give home owners and new buyers the option to easily build their dream home. This article describes the basics of what's involved in the construction loan process.

When you decide to build or remodel a home, a lender cannot offer you a traditional mortgage to do so. The reason lenders cannot offer a traditional mortgage is two-fold:

1. It is hard to determine the final value of the home until all construction is complete.

2. Since the money will often be paid to many different contractors, builders and professionals, the release of funding requires management.

Understanding the ins and outs of a construction loan before getting involved is important-we will review the basics.

What is a Construction Loan?

We define a construction loan as the following:

Any loan borrowed in order to finance the construction of a residential or commercial property. The funds are released to you incrementally as needed to complete certain construction phases. Typically, the monthly payments for a construction loan are based on an interest only payment plan.

Upon completion of the construction period the entire loan balance is due. At this point, the lender can convert the construction loan to a traditional mortgage or ask that you find another lender to refinance the construction loan into a traditional mortgage.

Essentially, a construction loan is a short-term loan-that must be paid off once construction period is complete.

Qualifying for a Construction Loan

Like any other type of loan, there are certain requirements that must be met. Each loan will vary, depending on the size and your personal credit. Sitting down and talking with a lender is a MUST, but an essential understanding of the requirements can help you begin preparing for the process.

Down Payment Requirements

One "problem" with construction loans, for many buyers, is the higher down payment requirements. Banks often like to see a 20% to 30% down payment. However, we have some basic tips to help you save for the down payment requirements in our previous article titled, " Saving for a Down Payment on a Home."

Credit Requirements

Your ability to repay is a primary concern for lenders. A higher credit score will qualify you for a lower rate and better terms. Lower scores may not qualify or could qualify but at a higher interest rate. Due to the uniqueness of many construction loans, the credit requirements will vary.

Income Requirements

Income and debt-to-income ratio is important to lenders. A higher income does not necessarily qualify you for a loan if you have large amounts of debt. Lenders are comfortable issuing loans to borrowers with a debt-to-income ratio at or below the 36% - 43% range.

Involving a General Contractor

Most lenders will have a requirement that a licensed contractor is involved before approving a construction loan. Check for the reputation of the builder by asking for a copy of their contractor's license and references to investigate their reputation.

Document Requirements

Proof of income, tax records and other documentation are necessary. You will need provide building plans, zoning documents and other legal documentation as well. Check with your lender for a list of all document requirements before you apply for the construction loan.

Appraisal Requirements

A pre-building appraisal may not be 100% accurate, but it is often a good estimate as to what the final value of the completed home will be. This will be a requirement from lenders in order to get a construction loan.

How Does a Construction Loan Work?

Once your project is approved and the lender issues the construction loan, they will release the funds in phases as the construction project progresses. Upon of completion of one phase, the funds for the next phase are released.

When the entire project is complete, in most cases, the loan is set up to automatically convert from a "construction loan" into a standard mortgage. This loan conversion is commonly known as a "construction to permanent loan."

How to Find a Construction Loan Lender?

It is important to remember that not every lender offers construction loans. Since it involves working directly with contractors and paying out to multiple vendors, the work involved is much more than with a typical loan. You will want to find a lender that specializes in construction loans and ask about their experience in this particular area before you commit.

Many construction lenders will be happy to share information on currently completed projects with you. Additionally, you may want to read reviews and check testimonials online. An experienced lender will make the process much easier and offer shortcuts or money saving tips during the process.

Construct Your Dream Home

While construction loans may be more complex than a typical mortgage, in most cases, you will only have one signing and one closing date. Most construction loans automatically convert into a traditional mortgage once construction is complete. However, if your construction loan does not convert automatically, you will simply need find a lender that offers "construction to permanent" loans.

This relative simplicity makes the construction process appealing-opening the door for more potential homeowners to have the home of their dreams.


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