What is a home construction loan?
A home construction loan is a short-term, higher-interest loan that provides the funds required to build a residential property, explained Janet Bossi, senior vice president at OceanFirst Bank.
“These loans are usually one year in duration during which time the property must be built and a certificate of occupancy issued,” said Bossi.
Unlike personal loans that make a lump-sum payment, the lender pays out the money in stages as work on the new home progresses, added Bossi. Borrowers are typically only obligated to repay interest on any funds drawn to date until construction is completed.
Construction loans have variable rates that move up and down with the prime rate, she added. And the rates on this type of loan are higher than those on traditional mortgages. Why are rates higher on construction loans? With a traditional mortgage, your home acts as collateral. If you default on your payments, the bank can seize your home. With a home construction loan, the bank doesn’t have that option, so they view these loans as bigger risks.
To obtain such a loan, the lender typically needs to see a construction timetable, detailed plans and a realistic budget.
“In order to obtain construction loan financing the borrower will need to have a builders contract including the draw schedule of how the builder expects construction funds to be advanced, a comprehensive budget outlining the cost or allocation for each construction item, and the timeframe in which the project is to be completed,” explained Bossi.
Once approved, the borrower will be put on a bank draft or draw schedule that follows the project’s construction stages and will typically be expected to make only interest payments during construction.
As funds are requested, the lender will usually send someone to check on the job’s progress.
Types of home construction loans
1. Construction-to-permanent loan
Construction to permanent loans provide the funds to build the dwelling and your permanent mortgage as well, explained Bossi.
In other words, under a construction-to-permanent loan, you borrow money to pay for the cost of building your home and then once the house is complete and you move in, the loan is converted to a permanent mortgage.
The benefit of this approach is that you have only one set of closing costs to pay, reducing the overall fees you’ll pay, said Bossi.
“There’s a one-time closing so you don’t pay duplicate settlement fees,” said Bossi.
Once it becomes a permanent mortgage — with a loan term of 15 to 30 years — then you’ll make payments that cover both interest and the principal. At that time, you can opt for a fixed-rate or variable-rate mortgage.
2. Construction-only loan
A construction-only loan provides the funds necessary to complete the building of the property, but the borrower is responsible for either paying the loan in full at maturity (typically one year or less) or obtaining a mortgage to secure permanent financing, said Bossi.
The funds from the loan are disbursed based upon the percentage of the project completed, and the borrower is only responsible for interest payments on the money drawn, Bossi added.
Construction-only loans are almost always tied to prime rate plus a margin. For example, your rate might be the current Wall Street Journal prime rate of 5.25 percent plus 2 percent more. “These loans are subject to a change in the interest rate every time the prime moves,” Bossi said.
Construction-only loans can ultimately be costlier if you will need a permanent mortgage as well. That’s because you will be completing two separate transactions and paying two sets of fees, said Bossi.
“These are two separate loans that are totally independent of one another,” said Bossi. “Two loans, two complete sets of financing expenses.”
One other point to keep in mind when considering this process. If your financial situation worsens during the construction process, due to a job loss, for example, you might not be able to qualify for a mortgage later on that actually allows you to move into your new house.
3. Renovation loan
A renovation loan can come in a variety of forms depending on the amount of money the homeowner is spending on the project, explained Rick Bechtel, head of U.S. residential lending for TD Bank.
“The range of the loan size would dictate what the right product might be and what options may exist,” said Bechtel.
“If you only need $10,000, you might opt for an unsecured (personal) loan, using a credit card or taking out a home equity line of credit (HELOC) against the existing equity in your home. A renovation loan could be any one of those product types,” added Bechtel. But as the dollar figure gets bigger, the more mortgage-like the product becomes.”
The challenge with smaller projects that involve either unsecured loans or HELOCs, said Bechtel, is that the review process is not as uniform or consistent as it is for a construction loan.
“With a construction loan, the bank is evaluating the builder as well as the customer, to make sure the builder is a good credit risk,” said Bechtel. “There’s a clear, professional process in place.”
A renovation loan on the other hand, particularly smaller loans, doesn’t require a budget being presented to the bank. Nor are draw schedules, plans and specifications required. The owner may just be writing a check up front to a builder.
“In the construction loan world, the bank is to some degree managing the process, including the builder and the customer,” said Bechtel. “In the renovation space, the homeowner is managing the whole thing with the builder, and the bank is often not aware of what is occurring.”
4. Owner-builder construction loans
Owner-builder loans are construction or construction-only loans where the borrower also acts in the capacity of home builder.
Most lenders will not allow the borrower to act as their own builder because of the complexity of constructing a home and experience required to comply with complex building codes, said Bossi. Lenders that do typically only allow it if the borrower is a licensed builder by trade.
5. End loans
An end loan is another name for a mortgage, said Bechtel.
“There is a construction loan that’s roughly 12 to 18 months in duration and is purely for construction. When the house is done that loan gets repaid,” said Bechtel. “And then you need to go out and get an end loan, which is just a regular mortgage. It occurs after you have completed construction.”