6 Essential Things to Know About Construction Loans

Using construction loans to build the home of your dreams can be more affordable and result in better results than searching for a ready-made home. Here are six essential things to know about construction loans.
Infographic with a building and people looking into construction loans

With rising home prices, many people find that their dream home appears to be out of reach. However, there are other options available. For example, if you’re willing to invest more time in planning and finding a suitable building partner, you can receive a loan to build your own home. 

By taking this option, you can completely control the building process and create a unique home built to your present and future needs. Not to mention, construction loans come with unique perks, such as an initial interest-only phase. So, if building your own home is something that might appeal to you, here are six essential things to know about construction loans. 

1. Construction Loans Can Cover Various Expenses

Naturally, construction loans have limits on what you can use their funds to pay for. Anything you put the expenses towards must be demonstrably related to the construction process. Four main expenses are involved in building a home, but construction loans cover all of them. These covered expenses are:

  • Labor
  • Materials
  • Permits
  • Land

The fact that you can use a construction permit to cover the land cost is particularly important, as it means you can use the loan to cover the entire home-building process. However, you’ll only receive the funds bit by bit throughout the lifetime of the home-building process. 

2. You Receive Funds on a Schedule

Instead of receiving the entire value of your loan immediately, as in a traditional mortgage, a construction loan entails multiple draws of funds throughout the process. 

This is an extra nuance to be aware of, but it helps keep projects on track and within budget. 

The approval for a new draw comes from an expert visiting the location and giving their approval at key milestones. This can come with purchasing a plot of land, laying the foundation, or other measurable steps throughout the construction process. 

3. They’re Usually Short-Term Loans 

Infographic of an explanation of construction loans

Construction loans typically have a term of six months to two years, which is the approximate amount of time that building a home takes. During this period, you only need to pay interest on the loan and will be able to defer payment on the principal. In theory, you may be expected to pay off the entire value of the loan at the end of this term. 

However, these lump-sum payments are unusual. Instead, the lender and homeowner generally negotiate new terms for the remaining loan value. If you can’t pay off the loan in full, then refinancing it to a standard mortgage is an option with most lenders.

4. There Are Different Types of Construction Loans

Depending on your priorities, you might not want a standard construction loan. There are other options to consider, as well as the fundamental concept of the end loan. 

  • Owner-builder construction loan: A special construction loan for individuals who are licensed and certified in the trades and who intend to build a home for themselves.
  • Renovation loan: A suitable option when you’re interested in fixing up or improving an existing home rather than building a new one from scratch.
  • End loan: The loan’s value after the end of the construction phase, when you typically refinance the loan as a standard mortgage. 

5. Requirements Are Mostly Standard, But…

Most of what you’ll need to file for your construction loan is effectively the same as pursuing a mortgage. In the bottom line, you need good credit, proof of income sufficient to pay back the loan, and a healthy ratio of existing debt to income. 

There’s a final step; however, that can vary from one lender to another. Most lenders want to ensure you have a plan in place for your home, from the initial purchase to the final stages of construction. Without this plan, they may turn you away, at least temporarily. It’s usually also necessary to have a builder approved before you can receive the loan, as most people don’t qualify for an owner-builder loan. 

6. Steps to Take in Securing a Construction Loan 

There are several steps to take if you’re looking for a construction loan. 

  1. Complete Pre Approval
  2. Find a Suitable Builder
  3. Develop a Plan
  4. File for Your Construction Loan

The first step to take is securing a preapproval for the financial side of your loan so that you know how much home you can afford to build. This is the easiest part of the process as well as the most important, which is why checking with a financial institution first is the way to go. Once you know what you can afford, shop for a suitable builder with the right cost balance and capability to suit your needs.

With your pre-approval in hand, you and your builder can work together to draft a plan for building your dream home. From there, you can seek approval for your construction loan. If you’ve completed the previous steps, this should mostly be a matter of stamping work you’ve already completed. From there, you’ll be able to start making progress toward building your new home with the help of your construction loan. 

You might also be interested in: 9 Tips To Consider Before Refinancing Your Mortgage Loan

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