Let’s say you have your exact your dream home designed in your head and are ready to hire the builder to get started. But can you use a conventional loan to build a house with a mortgage and make your dream a reality? Unfortunately the answer is no. Standard mortgage loans are used when buying an existing home, while construction loans are specifically designed to be used when you are having a home built.
This blog will explore the details of construction loans, like how they work, what you need to do to get one, making repayments, and why a credit union like Indiana Members Credit Union (IMCU) can be a great option for getting one.
How Do Construction Loans Work?
The basic idea of how a construction loan works is fairly straightforward. You apply for this type of loan when you are ready to begin building a home, and you will need to meet certain requirements to qualify. You and your builder will also be required to submit building plans, a budget, and a project timeline.
If you are approved for a construction loan, you will be able to draw funds from this loan at specific phases of the project. You will receive a draft or draw schedule that indicates when and how much of your loan cash will be available. This schedule will correspond to different phases of your home building project, and an inspector will be sent to evaluate the work before the next round of funds become available. Usually, the term for construction loans is one year, and the project will have to be finished and passed as safe to be occupied before the year is over.
Typically, the only repayments due on a construction loan during the building are interest payments. The entirety of the loan is usually due once the home is finished, at which point the construction loan converts to a permanent mortgage or a mortgage must be applied for and used to pay off the construction loan. The credit unions or banks that offer construction loans will make it clear which of these options are available before you submit your application. At IMCU, we have experienced loan officers who can walk you through the process and make it as easy as possible to build your dream house.
What Can Home Construction Loans Cover?
The budget and building plans you submit with your construction loan application will need to include a detailed list of costs for your home build. These costs can include:
- Land - You can use a construction loan to pay for the price of the land you will be building on, or you can build on land you already own.
- Materials - These are building materials for constructing the home, including things like lumber, appliances, and flooring, but not including things like furniture.
- Contractor and Manager Labor - There may be contractor and additional labor fees needed throughout the project.
- Permits and Inspection Fees - There will be many inspections needed over the course of the build and these can be paid for with a construction loan.
- Contingency Fund - A set amount (often a percentage of the total cost) that is specifically meant to cover unexpected expenses that arise during construction.
Is It Harder to Get a Construction Loan Than a Mortgage?
By their nature, construction loans are short-term loans without significant collateral, so lenders do view them as bigger risks than a standard mortgage. With a traditional mortgage, the home you purchase acts as collateral for the lender. They will have the home assessed to make sure it is worth as much as you are borrowing for it, and they will require you to have insurance to protect it. None of these things are possible when you are building a home that doesn’t exist yet.
If you have already looked into construction loans, you might have asked, why do construction loans have higher interest rates? This lack of collateral is the reason for these higher interest rates. It is also why construction loans may require things like higher credit scores and a higher percentage down payment compared to a traditional mortgage loan.
What Are the Requirements for a Construction Loan?
Many of the requirements for a construction loan are very similar to a standard mortgage, but as we just mentioned, there can be some differences. Each lender will vary slightly in their requirements, but at IMCU our construction loans will require:
- Good Credit Score
- Proof of Income
- Down Payment
- Detailed Plan of Construction Project, including builder and estimated final appraisal value of home
Let’s look at each of these in a little more detail.
Just like with most loans, a good credit score will give you the most options for a construction loan. Generally the minimum FICO score for construction loan is 680, but scores of 720 or higher would typically be preferred.
You will need to provide your construction loan lenders with proof of income in order to be approved for this loan. They will want to see not only how much you bring home each month, but also what your other debt payments are. For a construction loan, your debt-to-income ratio should be 45% or less. This means that if your monthly income is $10,000, the amount you pay for all your outstanding debts would need to be $4,500 or less. This debt includes things like car payments and student loans, as well as the new monthly payments from your construction loan.
For most lenders, you will need 20-25% of the full price of the build as a down payment. This is higher than what the average home buyer pays as a down payment for a standard mortgage because of the increased risk to the lender.
In order to apply for a construction loan, you will need to submit a lot of paperwork about how the building will progress. This is likely to include things like:
- Detailed building plans including timeline and budget
- Signed contract with a builder who is licensed and insured
- Estimate of appraised value of the finished home
Special circumstances in construction loans do come up, and speaking with knowledgeable loan officers, like the ones at IMCU can help you better understand your options. These circumstances might include things like questions about self-build construction loans, which generally aren’t eligible for special dispensations.
How Do You Calculate Construction Loan Payments?
Calculating loan payments on a construction loan is different from a traditional loan in two main ways. Firstly, it is not paid all in one lump sum at the time of house purchase—it’s paid out in stages as construction progress is made. Secondly, you typically pay only the interest on a construction loan, instead of paying a principal and interest payment. This makes sense when you think about the fact that you cannot be living in the house while it is being built, and you will also be paying a standard mortgage or rent on a different home during this construction phase.
Let’s look at an example of how you amortize a construction loan to make this clearer. If you are approved for a $300,000 construction loan to build your house, you will not actually be borrowing the $300k all at once. You may take a draw from your loan the first month to pay your builder for materials of $100,000. If you have a 6% annual interest rate, we divide it by 12 months to get a 0.5% monthly interest rate. This means your first month’s interest payment will be $500 (0.5% of $100,000).
After 3 months, you may draw another $100,000 to pay for the completed portion of construction. Now you will be paying interest on $200,000 of your construction loan amount, or $1,000 a month. At the end of your construction loan, after your home has been built, you will be paying interest on the entire amount you borrowed and the loan will be due.
Can You Roll a Construction Loan into a Mortgage?
The short answer is yes you can convert a construction loan into a mortgage once the home is built—as long as you have the type of construction loan that allows it. Let’s look at the two main types of construction loan to understand the longer answer.
This is a specific type of construction loan that is designed to convert to a permanent mortgage after the building phase is complete. The conversion will be part of the application and approval process, and the construction-to-permanent loan rates should be understood before signing.
Traditional Mortgage after Construction Loan
If your loan isn’t specified as construction-to-permanent, when the term of the construction term is over, the full principal will be due. For nearly every home buyer in this situation, you will apply for a new mortgage on the completed home that will allow you to pay the construction loan back.
Indiana Members Credit Union: Your Local Lender
At IMCU, we’re invested in seeing the people in our communities achieve their goals. We want to set you up for success with your house building dreams by making the construction loan process as straightforward as possible.
- We offer a one-time close construction to permanent loan, so you only have to deal with applications and the closing process once.
- Interest only payments during the construction phase, up to 12 months.
- Low down payment requirements, starting as low as 5%.
- Permanent loan terms up to 30 years.
Check out our construction loan page for more info, or connect with one of our loan officers today!