Future homebuyers may not realize they can build their own home without paying for construction out-of-pocket. Many lenders offer construction loans, which finance construction costs and allow homeowners to design their dream home without breaking the bank. Whether you are picky about floorplans and cabinet colors or tired of spending every weekend viewing new listings, it is worthwhile to learn about construction loans as an alternative option.
The first thing you should know is the difference between construction loans and loans for new construction purchases. One of your options as a homebuyer will be to purchase a new construction home from a builder. In this scenario, the builder owns the land and the home until construction is complete. You then purchase the completed home from the builder and receive a traditional conventional or jumbo loan product to finance the purchase. Lenders treat these transactions the same way they do existing homes.
However, when you take out a construction loan, you own the land, and your loan proceeds cover the cost of construction. This puts more control back in your hands. You can purchase the perfect plot of land and then shop for the best builder to make your dream home a reality.
What is a Jumbo Construction Loan?
A jumbo loan is a mortgage where the loan amount exceeds the county conforming loan limit, which is set by Fannie Mae and Freddie Mac each year. Anything above the loan limit is considered a jumbo loan. As of 2022, loan limits are about $647,000 for Texas and about $970,000 for high-cost-of-living areas in California.
If the cost of construction for your new home exceeds the county’s loan limit, then you will need to find a jumbo loan product. When shopping for a construction loan lender, be sure to check their loan limits! Lenders will often have a cap of how much they are willing to lend, and not all construction loan lenders are willing to originate jumbo construction loans.
Construction Loan Requirements
Although there are some lenders who can roll the land purchase into the construction loan, most construction financing requires you to own the land in advance. The good news is that your ownership of the land will contribute to your starting equity when calculating the necessary down payment. Most construction loans have a minimum 10% down payment. If you are pursuing a jumbo construction loan, then the minimum down payment could be as high as 20%.
Construction loan lenders will also have a minimum credit score. Credit score thresholds will depend on the lender, but a score of at least 680 is usually required. If you are putting down a smaller percentage or obtaining a jumbo loan, then expect to need a higher credit score (up to 720 in some cases). Guidelines vary from lender to lender, so be sure to shop around for the product that best fits your unique profile!
How Do Construction Loans Work?
There are two main types of construction loans: a one-time close and a two-time close.
The one-time close construction loan is also called “construction-to-permanent” financing. This type of financing gives you one loan that funds construction of a new home. When construction is complete, the loan converts to a traditional mortgage. You only have one loan closing, and you don’t have to worry about changing interest rates during construction; your permanent rate will already be locked in.
In contrast, a two-time close has two separate loan closings. The first loan funds the construction of the property and is called a “stand-alone” construction loan. When construction is complete, your lender will requalify you for a permanent loan using traditional loan products. Although the two-time close causes you to go through the underwriting process twice and pay an additional set of closing costs, it does provide more flexibility during the construction process if certain aspects of the project change. It can also allow you to roll-down your interest rate if rates lower during the construction term.
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October 6, 2022
View mortgage rates for October 6, 2022
What Are the Steps To Get a Construction Loan?
The first step to obtaining a construction loan is to research potential construction loan lenders and get pre-approved. Your lender will request information about the type of home you are hoping to build, your income, assets, and credit. This will allow the lender to advise on what construction loan product you qualify for and make sure their services suit your needs.
Once you find a potential construction loan lender, shop different builders, and select one that you love. Make sure the builder is reliable and responsive. Provide the builder information to your lender, and the lender will approve the builder through their own approval process.
Now that you have a lender and a builder, you can finalize the construction project plans. After all plans are finalized, you can start the closing process for your construction loan. Expect to provide financial documents such as paystubs and bank statements to your lender as you move through the underwriting process. Your lender will also order an appraisal that assesses the value of the home based on project plans. You will sign construction loan documents at closing, and your loan will fund!
Unlike traditional loans, the proceeds of your construction loan are not released all at once. Instead, the loan funds in increments or “draws” for work that has already been completed. Lenders arrange inspectors to visit the project, verify that certain work items have been completed, and then release loan draws to reimburse the costs. Loan interest accrues based on how much of the loan has been drawn upon, and you will make monthly interest-only payments during construction.
When the build is complete, your construction loan will either 1) convert to a permanent loan if it is a one-time close, or 2) be paid-off with the proceeds of your permanent loan if it is a two-time close.
Finally, your dream home will be yours! Construction loans have a few extra steps in comparison to traditional loan products, but the extra effort could be worth the wait to have a custom-built home perfect for you.