How Do Home Construction Loans Work?

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The average cost to build a single-family home in the U.S. came close to $300,000 in 2019, according to the National Association of Home Builders. Many of us, of course, don't have that much money to plunk down on a new home. That's why many prospective home builders borrow money to build a new home through what's known as a home construction loan.

Simply put, a home construction loan covers the costs of building a new home, including materials and labor. The proceeds of a construction loan also can be put toward renovating a home. However, construction loans typically come with one big drawback that mortgage loans don't have: a higher interest rate.

Follow along to build your knowledge of construction loans.

What Is a Home Construction Loan?

A home construction loan enables you to pay the costs associated with building a home and to buy the land for the home. The builder, not the borrower, usually receives the money through several advances paid throughout the construction process.

While the home is being built, the only payments you must make go toward the interest. Full payments of the home construction loan start six to 24 months after you take out the loan.

A home construction loan typically carries stiffer requirements than a traditional mortgage loan. Why? Because when you buy a home, the lender can seize the property as collateral if you fall behind on payments. But if you take out a home construction loan, there's no collateral to take possession of until the home is built. Therefore, a lender assumes more risk when it signs off on a home construction loan.

Requirements for a home construction loan may include:

  • Solid credit score.
  • 20% down payment.
  • Substantial amount of savings.
  • Low debt-to-income ratio. This compares your monthly debt obligations with the amount of money you earn.
  • Signed contract with licensed builder.
  • Detailed construction plans. The lender may ask for information factors such as the home size, the lot size and the construction materials.

Once the term of the home construction loan ends (normally after 12 months), you must either pay off the entire balance or obtain a traditional mortgage to cover the balance. A mortgage usually comes with a 15-year or 30-year payoff period.

Types of Home Construction Loans

Five types of home construction loans are available. They are:

  1. Construction-to-permanent loan: This loan mixes construction financing with conventional mortgage financing. Once the home is completed, the loan switches from a construction loan to a mortgage loan.
  2. End loan: With this type of loan, the builder pays for construction of a home, and the buyer takes out a mortgage to purchase the home directly from the builder.
  3. Owner-builder construction loan: Are you a homebuilding guru? If so, you may want to explore an owner-builder construction loan. With this type of loan, you serve as the general contractor rather than hiring one.
  4. Renovation loan: To pay for a major home overhaul or a home addition, a renovation loan may be an option. This sort of loan lets you borrow against the predicted value of your renovated home.
  5. Construction-only loan: Most lenders no longer provide this kind of loan. A construction-only loan covers construction costs and must be paid off when the term of the loan expires. Otherwise, the borrower must obtain permanent financing.

How and Where to Get a Home Construction Loan

To qualify for a home construction loan, you'll generally need a credit score of at least 620 (although the higher, the better), a debt-to-income ratio of up to 45%, proof of your ability to pay off the loan, a down payment covering 20% to 25% of the construction costs, a signed contract with a licensed and insured builder, an appraisal of the value of the land and completed home, and a complete blueprint for the project.

Banks, credit unions and mortgage lenders are among the places where you can obtain a home construction loan. You might start by comparing interest rates, closing costs and other loan aspects at lenders in the area where your home will be built. In doing so, remember that you may want to take out the initial construction loan and the permanent loan at the same lender to make things more convenient.

Things to Consider Before Applying for a Home Construction Loan

If you decide to apply for a home construction loan, ask these four questions:

  1. Is your debt-to-income ratio low enough to qualify for the loan? If it's not, work toward reducing your debt or bumping up your income to improve it.
  2. Do you have enough money set aside for a down payment? If not, begin saving up to make at least a 20% down payment.
  3. Where does your credit score stand? If your credit score is below 620, focus on reducing debt and paying bills on time to raise your score.
  4. Do you have all of the necessary paperwork? A lender may want to see pay stubs, tax returns, bank statements and other financial documents before approving your application for a home construction loan.

Bottom Line

Before you go ahead with an application for a home construction loan, check your free credit report from Experian to ensure your credit is in the best shape possible so you can score a low interest rate.