Types of Construction Loans - Which is Best for Your Project?

Building a new home has its advantages over purchasing a new home, such as designing the home to your specifications. You have the opportunity to create your dream home; however, the loan process is quite different. New construction requires another type of mortgage than that of a ready-built home. There are numerous options for construction loans, and in this article, we will go over what a construction loan is, the types of construction loans, and what you should know to pick before choosing the type of construction for your project.
construction loans for various projects

What is a Construction Loan?

A construction loan for a new home provides the borrower the money they need to build their home. These types of loans are typically for one year. During that time, the property build must be complete, and the homeowner must obtain a certificate of occupancy. In addition, the borrower may use this type of loan to purchase the land where the home will be built and pay for contract labor costs, building supplies, permits, and other expenses associated with the build.

It is critical to address the above factors with the lender, particularly the loan-to-value calculation costs. Construction loans often contain a contingency reserve for unforeseen expenditures that may emerge during the build, which can act as a cushion for the borrower if he decides to make changes once construction begins. While house furnishings are often not covered by a construction loan, the lender may include permanent fixtures such as appliances in the loan.

What is the procedure for obtaining a construction loan?

Attempting to finance a real estate project can be extremely difficult. Things appear to get even more difficult if you want to finance construction loans. With that said, there are many different types of construction loans to consider. It is, however, important to note that many lenders consider construction loans to be extremely risky investments. Loan officers and the management for whom they work carefully examine proposed construction projects before deciding whether or not to fund the transaction.

Construction loans often feature variable interest rates that can fluctuate with the prime rate. The interest rates associated with construction loans are also generally higher than mortgage loan interest rates. With a typical mortgage, your house serves as collateral, and if you fall behind on payments, the lender can seize your home. Because the lender does not have that choice with a home building loan, they tend to regard these loans as higher risk.

Because construction loans have a tight timeframe and are contingent on the project's completion, the lender will require a timeline, comprehensive blueprints, and a realistic budget. Once authorized, the borrower will be placed on a draft or draw schedule that corresponds to the project's development stages and will generally be required to make interest-only payments during this time. Unlike personal loans, which require a single sum payment, the lender disburses funds in phases while construction on the new home progresses. As a result, borrowers are generally only required to pay interest on any monies spent up to that point until construction is complete.

The lender has an appraiser or inspector assess the house at various construction phases. If the appraiser approves, the lender will issue extra payments to the contractor, known as draws. Depending on the kind of construction loan, the borrower may be allowed to convert the loan to a regular mortgage after the house is complete or obtain a separate mortgage to pay off the construction loan.
choosing a type of construction loan for your project

Types of Construction Loans

Several options may be available for the construction of a new home. Below are some of the more common types of construction loans.

Construction-to-Permanent Loan

A construction-to-permanent loan provides funding for both the construction of the home and the permanent mortgage. In other words, the lender provides funds for the home's structure, and then the loan is converted to a permanent mortgage once the homeowner moves in. The advantage of this technique is that there is only one set of closing costs, which reduces the overall fees.

When it becomes a permanent mortgage, generally with a loan duration of 15 to 30 years, the homeowner can start making payments that cover both interest and principal. In addition, the homeowner typically has the option to choose between a fixed-rate and an adjustable-rate mortgage.

Construction-only financing

A construction-only loan provides the cash required to finish the property's development. These construction loans release funds as needed, and the borrower is only liable for interest payments on the money used. However, the borrower is responsible for repaying the loan fully at maturity (usually one year or less) or getting permanent financing through a mortgage.

Most often, lenders base construction loan rates on the prime rate plus a margin. Furthermore, they may have a higher interest rate than regular mortgages. Construction-only loans might be more expensive in the long run if the borrower needs a permanent mortgage because the borrower will have two separate transactions and pay two sets of fees.

Construction financing for the owner-builder

Owner-builder loans are construction or construction-only loans in which the borrower also serves as the house builder. Most lenders do not allow the borrower to operate as the builder due to the intricacy of constructing a home and the knowledge necessary to comply with construction standards. Lenders that do allow owner-builder loans generally do so only if the borrower is a licensed builder by trade.

Considerations for Construction Loans

Before choosing a construction loan:
  1. Consult with your contractor about the timeframe for building the house and whether other circumstances, such as severe weather, might cause delays.
  2. Determine if you want to go through the financing process only once or twice.
  3. Consider how much the closing expenses and other fees associated with getting several loans will add to the project.
When applying for a construction loan, you must consider the cost of building the house, the cost of purchasing the property, and determining how to manage the whole cost afterward, possibly with a permanent mortgage when the house is complete. In order to prevent multiple closings, a construction-to-permanent loan may be appropriate.

hard money loans for commercial or residential projects

Hard Money Construction Loan

Construction loans through hard money lenders are short-term loans used to back real estate investment property. This type of loan generally comes with a higher interest rate; however, the barrier to entry is much easier than a commercial loan, and funds are usually available much quicker. In addition, the lender will use the property as collateral to secure the loan.

Using a hard money lender is an important option for developers who need funds to get new construction projects up and running but do not qualify for loans from traditional lenders. They may also be appropriate for projects with specific deadlines that must be met or if you simply do not want to sit around waiting for a government or traditional loan to be approved. Let's look at how hard money construction loans differ from traditional financing so you can make the best decision for you and your needs.

Loan for Renovations

If you want to renovate an existing house rather than create a new one, you may seek a renovation loan, which comes in many forms depending on the amount of money you want to spend on the project.

If a homeowner has a budget of $25,000 for remodeling, they may consider taking out a personal loan to finance the project. If your home has built up enough equity, you may also consider a home equity loan or line of credit for improvements. Because of their low-interest rates, HELOCs are generally the most economical option to borrow a significant quantity of money."

Cash-out refinancing is another viable alternative in the current low mortgage rate environment. A homeowner takes out a new mortgage for a more significant amount than their existing loan and receives the difference in a lump payment. In most cases, the lender does not demand notification of how the homeowner will use the funds. The budget, strategy, and costs are all managed by the homeowner.

Using a construction loan to fund a refurbishment, on the other hand, is a more extensive process. Unlike different types of financing, the lender will examine the builder, check the budget, supervise the draw timeline, and manage the process as a whole.

How to Get a Home Improvement Loan

At first look, the procedure of obtaining a construction loan appears to be identical to that of acquiring a mortgage. It does, however, have a few additional needs.

Before applying for a construction loan, a borrower should have met with an architect, had drawings and specifications produced, and negotiated a contract with a builder representing the overall construction cost so the borrower may establish a loan amount.

In addition to a thorough evaluation of the plans and specifications, lenders consider a borrower's job history, savings, income stability, and capacity to repay the loan. They also require a property evaluation to corroborate the collateral's value.

To qualify, you will most likely need:
  • Excellent to good credit
  • Consistent earnings
  • Having a low debt-to-income ratio
  • A 20% down payment is required.
choosing a lender for your construction loan

Choosing a Lender for Your Home Construction Loan Type

Because construction loans are more complex than regular mortgages, choosing a lender who specializes in construction lending and is familiar with the process is essential. Examine different lenders to learn more about their particular programs and procedures. Remember to check construction loan rates, terms, and down payment requirements to ensure you're receiving the best deal available for your construction project.

Locating a lender that will work with you to meet your specific needs can be difficult. Working with a private money/hard money lender simplifies the process due to their requirements. In addition, they may be more flexible with providing you a loan than other types of construction loans. We hope you found this article helpful. At Liquid Logics, our mission is to help make the loan process more manageable and efficient through state-of-the-art loan software. If you are someone you know is looking for the best loan software on the market, contact us today.