Building a home from the ground up allows you to work with a builder and customize your living space. However, when you start from scratch you’ll also need to decide the best way to pay for the home while it’s under construction. Some builders will secure their own financing, but others may ask you to obtain a construction loan. In these cases, it pays to understand the ‘whys’ and ‘hows’ of financing a property during the building stage.
What is a Construction Loan?
Typically granted for a short-term period (up to one year), this loan is used to finance the building of a new home with the expectation that at the end of the term, the homeowner will pay off the construction loan and obtain a mortgage. Construction loans do not typically cover the cost of the land on which the house will be built. If you already own the land on which you intend to build, you may use it as collateral.
Preparing for the Application Process
Construction loans are typically more difficult to obtain than a traditional mortgage. This is due to the perceived additional risk associated with the building project. One risk lenders take into account is the chance that construction will not be completed as scheduled. Another risk is that the final product (your new home) will not be valued at the amount anticipated when the loan was originally approved. Thus, you should expect to put forth a larger down payment to finance the building process. When preparing to apply for a loan, make sure your builder is ready to begin construction. Formal plans should already be drawn up and approved. To improve your chance of successfully obtaining financing, your contractor should also have the proper accreditation and a proven track record of prior construction.
How Construction Loans Work
Due to increased risk, expect to pay a higher interest rate for a construction loan compared to a mortgage. Rather than allowing one lump sum payment for the entire project, funds for construction are released by the lender as needed throughout the building process, on a monthly basis or as otherwise agreed. Lenders may exercise their right to oversee the building process and request proof of work completed to date prior to releasing additional funds. Payments are usually interest-only during the term of the loan, based on the amount of funds released at the time of the interest due date. When construction is complete, the borrower will obtain a mortgage and pay off the balance of the loan. Alternatively, a construction to permanent loan is an option which converts the construction loan into a mortgage without the need for a second closing.
If you’re working with a contractor to build a home from the ground up, a construction loan may be the best option for you.