Home Construction Loans

What is a Home Construction Loan?

man in overalls jumping into the air holding house plans in front of house

If you want to build a home to your own specifications but don't know how to pay for it, a home construction loan could be the perfect solution. While home construction loans can be a little harder to get than regular home loans (especially since you don't have a finished home as collateral), lenders usually monitor the process to make sure everything's on track.

How Home Construction Loans Work

In most cases, home construction loans are only offered for short periods of time, often one year or less. Unlike regular home loans, home construction loans are paid to the construction contractor, not the borrower, in installments called draws. Each draw is associated with a new stage in the home's construction, such as laying the foundation or framing the home. In most cases, the lender will send an inspector after each stage of the home is complete before authorizing a new draw. In addition, most home construction loans are variable (not fixed-rate) loans, so they can go up or down based on market interest rates.

Different Types of Home Construction Loans 

There are three main types of home construction loans, and each can be a good choice, depending on the specific situation that you find yourself in. The three most common types of home construction loans include:

  • Construction-to-permanent construction loans: This type of construction loan only closes once, and converts to a permanent mortgage when the home is finished. The construction portion of the loan is still often set an an adjustable rate, but the permanent part of the mortgage is usually offered as a fixed-rate loan.

  • Construction-only loans: These loans, also known as "two-close" loans, need to be paid off completely when the home is finished. Therefore, construction-only loans are really only a good idea if you have a decent chunk of change, are willing to pay two rounds of closing costs, and want to take more time to shop around for a permanent mortgage lender.

  • Renovation construction loans: Renovation construction loans are more like traditional mortgages, since the renovations will be included in the cost of the new mortgage. Unlike regular home loans, the loan is based on the value of your home after the renovations.

What Do I Need to Get a Home Construction Loan? 

silhouette of men working

Since a home construction loan can be somewhat riskier for a lender than a traditional mortgage, they'll want to see that you know exactly what you're doing -- and that you have a smart plan to have your house built on time and on budget.

Lenders will usually require the following before approving a construction loan:

  • Construction timetable: Since lenders will only issue new funds after each stage of home construction is complete, they want to see exactly how long the process is going to take.

  • A realistic construction budget: Before they decide to lend you money, lenders need to know if you (and your contractor) can complete the home with the amount of money they're giving you. A lender's worst nightmare is a broke borrower with a half-finished house, since they can't sell a half-finished house to pay off your debts.

  • Detailed architectural plans: Lenders also want to know exactly what you're building -- and if it matches up with your timetable and budget. So, while you might like to freestyle, it's unlikely your lender will feel the same way.

To create the documentation you need, you'll likely need to meet and consult with a good construction contractor and a high-quality architectural firm. Since you'll be working with these people for six months to a year (or more), and you're likely trusting them with hundreds of thousands of dollars, it's a good idea to do your research and only work with trusted, experienced professionals. 

FHA Construction Loans 

If you want a home construction loan but you're having trouble qualifying for a construction loan from a private lender, the FHA might be able to help. The Federal Housing Administration insures short-term construction loans that convert to permanent mortgages when the completion of your home is finished. Since FHA construction-to-permanent mortgage loans have only one closing, they can help you save on closing costs and fees -- as well as other expenses.

FHA Construction Loan benefits 

  • Ultra-low down payments. Like other FHA loans, FHA construction loans can be secured with a down payment as low as 3.5 percent.

  • An interest-only period. FHA construction loan borrowers do not have to pay the principal during the construction portion of the loan.

  • Less stringent credit requirements. If you have a credit score of 620 or higher, you may qualify for a FHA construction loan.

  • Higher debt-to-income ratio allowed. Unlike privately insured construction loans, the FHA is not as strict when it comes to enforcing DTI requirements for borrowers.

fence on large grass area with mountain in background

Land Loans 

If you've found the perfect piece of land, but you aren't yet ready to build a home there, you might want to look into getting a land loan. Like home construction loans, land loan borrowers don't usually have collateral to secure their loans, which means that these loans will usually have higher interest rates and bigger fees.

Before making the decision to buy land, it's essential to make sure that the property is properly zoned for the type of home that you want to build. To do that, get a professional land survey to access the property's exact property lines and any easements that may affect future construction.

Home Improvement Refinancing with an FHA 203(k) Loan 

If you're not looking to build an entirely new house but rather to make your current one a little nicer, the FHA may have another solution for you. The FHA's 203(k) program allows homeowners to refinance their homes, rolling the cost of the renovations into their new mortgage payment. This can be a much more cost-effective solution than using higher-interest loan options, like personal loans or credit credits, to finance home remodeling costs. Like other FHA loans, the Federal Housing Administration does not actually offer the loans, it only insures them. FHA 203(k) loans come in two flavors: limited 203(k) insured loans, and standard 203(k) insured loans, both of which are described below.

Standard FHA 203(k) Insured Loans 

  • Mortgage limit based on median sale prices in a homeowner's given area ($5,000 minimum required)

  • Only one contractor allowed, who can subcontract work to others

  • Projects must be completed six months after loan closing

  • Allows for larger projects, like adding rooms or replacing plumbing

  • Inspections are always required, no matter the size of the loan

Limited FHA 203(k) Insured Loans 

  • Can offer $35,000 of financing (no minimum amount required)   

  • Multiple contractors can be used for different projects 

  • Projects must be completed 60 days after loan closing 

  • Allows for smaller repairs, like replacement of kitchen countertops or flooring

  • Inspections not required for loans under $15,000

Pros and Cons of Home Construction Loans

Building your dream home can require a lot of cash -- so, if you're not already rolling in dough, you'll need a home construction loan to help out. While a home construction loan might be able to help you build the house you really want, these loans aren't without certain drawbacks. Below, we go over some of the biggest pros and cons of home construction loans. 

Benefits of Home Construction Loans 

  • Interest-only options. If you get a construction-to-permanent construction loan, like the FHA construction-to-permanent loan mentioned above, you'll only pay interest during the home's construction period.

  • Allows you to build the home you really want. While there are a lot of amazing homes out there, you might not find the perfect home in the perfect location. So, instead of settling for something you don't love, a home construction loan allows you to create the perfect abode -- whether it's a mansion for a huge family or a sweet little bachelor pad.

  • May make it easier to create a stream of rental income. With long-term rental websites like AirBnB becoming increasingly popular, building a bedroom with a private entrance or a small cottage on your property could provide you with a great source of income to help pay your mortgage later.

Drawbacks of Home Construction Loans

  • More expensive than regular home loans. Due to the additional risks of home construction loans, interest rates and fees are usually higher than traditional mortgages.

  • Variable interest rates can increase over time. Unlike ARM home loans, for which interest rates are usually adjusted once every six months or year, home construction loan ARMs may be adjusted once a month, or once a quarter, for the duration of the construction period of the loan.

  • Subject to regular inspection by the lender. Since the lender will mandate a home inspection before the beginning of each new payment installment, or draw, you could be in hot water if the lender doesn't like what they find.

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Who’s the Ideal Borrower for a Home Construction Loan?

If you want a home construction loan, you should probably be really committed to the idea of designing and owning your own home. Otherwise, it could be a lot less expensive for you to simply buy an existing home, and not have to deal with all the extra shenanigans of the home building process.

Construction loan Eligibility Requirements

To be an ideal candidate for a home construction loan, you should: 

  • Have good credit and a decent amount of savings 

  • Have a decent debt-to-income (DTI) ratio 

  • Have a good home construction timetable, an accurate budget, and detailed architectural plans

Home Construction Loans: In Review

Home construction loans can provide ordinary people the ability to build the home of their dreams. While they do have more stringent requirements and higher interest rates, for the right kind of borrower, these may be an excellent investment. 

While we try to offer super-sage advice here at home.loans, every borrower has different needs when it comes to finding the perfect loan. So, if you're confused (or just want to talk about the weather for a few minutes) drop us a line -- we're here to help!