How to Get a Construction Loan? [2022 Guide]

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If you’re thinking about building a new home, getting a construction loan may be a good idea. Construction loans can be a little tricky, though – that’s why we’re here to help!

In this article, we will explain how to get a construction loan, how it works, and what the requirements are. We’ll also provide some tips on how to get approved for a construction loan.

So if you’re ready to start building your dream home, keep reading!

What Is a Construction Loan?

A construction loan is a short-term loan that you can use to finance the construction of your home. It’s different from a traditional mortgage because it’s designed specifically for people who are building a new home.

The interest rates for construction loans are usually a little higher than the interest rates for traditional mortgages. This is because there is more risk involved in home construction loans since there is no collateral. However, you can often get a lower interest rate if you have a good credit score.

DID YOU KNOW: While the cost of building a house depends on a variety of factors, you can get up to 90% of your property’s value as a construction loan.

What Does a Construction Loan Cover?

A construction loan covers a variety of things that make up the cost of building your own home. Here are a few of them:

Interest reserves

Some lenders may require you to set up an “interest reserve” as part of your construction loan financing. This is a savings account that will hold enough money to cover the interest payments on your loan for the duration of the construction period. This helps ensure that you won’t miss any payments.

Contingency reserves

In addition to an interest reserve, you may also be required to set up a “contingency reserve”. This is an account that will hold money for any unexpected costs or repairs that may occur during the construction process.

Labor and materials

Homebuilding loans can also cover the cost of materials and labor for your home construction project. However, there are usually limits on how much money you can borrow for this purpose. You will need to provide documentation that shows how much money you have already invested in the project.

Closing costs

Closing costs are the total of all the expenses and fees you have to pay when you complete the purchase of your home. They include the cost of hiring a real estate agent, getting a home inspection, and other related expenses.

Land

Getting a loan to build a house also includes the land. You can use a construction loan to purchase land for your home.

Permits, plans, and fees

You will need to provide architectural plans for your home in order to get a construction loan. The lender will use these plans to determine how much money they are willing to lend you. The construction loan can also cover the cost of permits as well as other fees involved in the process of building your home.

How Do Construction Loans Work?

Now that we’ve understood what is included in a construction loan, let’s see how these loans work:

Loans for new construction

If you’re planning to build a new home, this is the ideal construction loan for you. Loans for new construction are used to finance the construction of a brand new home. They usually have lower interest rates and longer repayment terms.

Loans for home remodeling

Construction loans are not limited to building a brand new home but also include renovations if you choose loans for home remodeling. Renovation construction loans can be used to finance the renovation of an existing home.

Owner-builder loans

Some lenders offer construction loans specifically for owner-builders. Owner-builders are people who build their own homes rather than hiring a contractor. Construction loan interest rates for this type of loan are usually low when compared to other construction loans.

End loans

When your home is finished, you will need to take out a separate mortgage to pay off the construction loan. This mortgage is known as an “end loan“. The end loan can be a traditional mortgage or it can be a special type of loan designed specifically for the purpose of paying off a construction loan.

DID YOU KNOW: You can also consider a home improvement loan if you wish to simply renovate your home.

Types of Home Construction Loans

Let’s discuss the various types of loans in detail:

Construction-only loans

Some lenders may offer a “construction-only” loan. This is a loan that can only cover the cost of building your home. You will need to take out a separate mortgage to pay off this loan once your home is finished, so construction-only loans are ideal for people who already have a mortgage.

Renovation construction loans

Renovation loans are another type of homebuilding loan. These loans can be used to finance the renovation of an existing home. They usually have lower interest rates and longer terms than construction-only loans.

Construction-to-permanent loans

These loans are used for both the building costs and for financing the mortgage. This type of loan allows you to borrow money at a lower interest rate than you would with a traditional mortgage.

DID YOU KNOW: Many people confuse home equity loans and construction loans. Research thoroughly before you take any type of loan to make sure it’s the best fit for your situation.

Key Takeaways

Most of us are aware of how mortgages work, but can you get a loan to build a house? Yes, these loans are known as construction loans.
A construction loan is a short-term loan that is used to finance the cost of building a home.
Some of the things included in construction loans are interest reserves, labor & materials, closing costs, land, etc.
You can get a construction loan to build a new house from scratch, renovate an existing one, or get an owner-builder loan.
The different types of construction loans are construction-only loans, renovation construction loans, and construction-to-permanent loans.

Construction Loan Requirements

Here are a few requirements you need to fulfill as a borrower to get approved for a construction loan:

Credit score

The credit score requirements for a construction loan vary from lender to lender. You can get home loans with bad credit, but most lenders require a credit score of at least 640. The higher your credit score is, the better the repayment conditions.

Debt-to-income ratio

The debt-to-income ratio shows the percentage of your monthly income that goes towards paying your debts. The debt to income ratio requirement for a construction loan varies from one contractor to the other. However, most lenders require a debt-to-income ratio of no more than 50%.

Down payment

Down payment for a new construction loan will also vary from one lender to another. However, most lenders require a down payment that is at least 20% of the total cost of building the house.

Repayment plan

The specifications of the repayment terms will be decided between you and your lender. In most cases, the repayment budget plan involves monthly installments paid throughout the construction period. You can also decide between single-close construction loans and two-close construction loans.

DID YOU KNOW: Lenders can also ask for a copy of your building plans while reviewing your construction loan application.

How to Get a Construction Loan?

Now let’s discuss what steps you need to take to get a construction loan. Here is the step-by-step process:

1. Decide on the type of loan

We’ve already discussed the different types of construction loans available. Understand the pros and cons of each type before deciding which one you want.

2. Review your credit score

Most lenders will require you to have a credit score of 640 or higher. There are ways to fix your credit score so that you can get approved and get good construction loan interest rates.

3. Find a licensed builder

It is important to work with a licensed builder, as they will be familiar with the building codes and regulations in your area. If you do not comply with these, you may end up having to tear down your house or pay expensive repair costs. The builder will be able to carry out an inspection and help you in the building process.

4. Prepare all the needed documents

What else do you need for a construction loan? Most lenders ask for income proof, proof of ownership, identity proof, appraiser’s estimate of value as well as blueprints for the construction plan.

5. Get pre-approved

It is important to get pre-approved for a construction loan before you start the construction process. This will ensure that you are eligible for a loan and it will also help you negotiate a better interest rate.

DID YOU KNOW: As per stats, overall construction loans by US banks totaled $385.72 billion in 2020!

Conclusion

A construction loan is a short-term loan that is used to finance the cost of building a home. It provides for interest reserves, land, labor, and materials, as well as closing costs.

There are different types of construction loans available and you should choose the one that best suits your needs. To get approved, you must have a good credit score and a low DTI ratio. Always check what the exact requirements for approval are as they vary from lender to lender!

FAQ

Do you have to make a down payment on a construction loan?

Yes, most lenders require a down payment of at least 20%.

Is it hard to get a construction loan?

If you know how to get a construction loan, it is not hard. Just make sure you know the process and meet the lender’s requirements.

Sources

ABOUT AUTHOR

I learned a lot about finance after working for a digital marketing company specializing in investing and trading stocks, forex, etc. After that, I got exposed to other verticals such as wealth management and personal finance, which further improved my understanding of the financial world.

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