How does a construction loan work for building a new house?
Congratulations on wanting to build a new home! It’s an exciting process, as you get to design your home exactly as you want it. You finally get to put into action the vision that you’ve been gathering throughout the years. However, before you fully commit, it is important to consider the costs of building a home from scratch. Building a new home costs a lot of money, and most people can’t afford to pay for it up front. Thus, you’ll likely need to borrow. A loan for a newly built home is unique due to the fact that a homeowner is asking the bank to front something that does not yet exist. As you’d imagine, banks consider this to be a significant risk. Hence, a construction loan is a provided option for homeowners building a new home.
What is a construction loan?
Construction loans are short-term (usually up to a year) in which the lender takes an ownership interest in a house that is being built. Basically, a construction loan is funded by the bank to pay for construction all throughout the project. The buyer is responsible only for interest payments while the house is under construction. The balance of the is paid at the end of the term generally by a mortgage that is purchased once the home is completely built.
How does a construction loan work?
Before the loan is finalized, the lender will need specific information to prompt them to back the project. This information may include:
- Credit score: borrowing will not be granted if you do not have a good credit score
- Construction blue print: floor plans, dimensions, construction timetable, budgeting, etc.
- Appraisal: Even though the home is not yet built, the bank will have an appraiser review the construction blue print to determine the home’s likely value.
- Proof of income: The bank needs to feel comfortable with the homeowner’s likelihood of paying off the loan.
Often times, the loan meeting will include all three parties–lender, buyer, and builder–to ensure everyone is on the same page.
Once the loan is approved then the construction can begin. An amount will be set aside by the bank to fund the construction project at specified levels of completion. These amounts are known as draws. So, say you get a $100,000 construction loan with an interest rate of 4%. The bank will pay the builder $10,000 when the loan closes, $10,000 when the foundation is set, and so on…up until the house is fully built. Again, the buyer will only owe the interest throughout this process; the balance itself will not be owed until after the project is complete. Additionally, the interest is paid based on the draw amount, not the loan amount. In this instance, you would owe 4% of the $10,000, not the $100,000.
Once the construction is done, you can then have it refinanced to get a mortgage on your new home. The remaining balance of the loan can be covered by the mortgage. If all goes according to plan, the home is built on time, your loan is paid off, and you’re ready to settle down in your new home.
Should I get a construction loan?
Unfortunately, you don’t have much of a choice when building a home from the ground up. Banks will always consider loans for newly built homes to be a considerable risk. In fact, most national banks don’t even offer construction loans. You’ll most likely have to obtain one from a regional bank or a credit union. Ultimately, a construction loan works out fine as long as four things in are place: a good credit score, a healthy income, and a healthy housing market, and a reliable builder. Healthy income is important, as the lender will charge the buyer in the event that construction gets behind. A healthy housing market is also key, as it reassures the value of their investment.
We want to make sure you’ve covered all of your basis before you dive into a new home! Ryan Hartman Custom Homes offers the best home advise. From lot selection to loan financing, we are the top consultation source in Dallas.
