The Basics of Construction Loans: Buy Land and Build
Mortgages are easy to find, but there’s usually a catch: you can only borrow money to buy a place that already exists. Construction loans are different because they can fund everything needed for a new home, garage, or business structure. They can also work when renovating or buying land (if you don't already have it).
Construction loans are less popular than standard home loans, but they are available from numerous lenders. If you’re thinking of building, learn about the basics and find out how each lender handles the specifics.
How Construction Loans Work
A construction loan is a short-term loan for real estate. You can use the loan to buy land, build on property that you already own, or renovate existing structures if your program allows. Construction loans are similar to a line of credit because you only receive the amount you need to complete each portion of a project. With construction loans, you only pay interest on the amount borrowed (as opposed to a standard loan, where you take 100% of the money available up front and start paying interest on the entire balance immediately).
Payments: During the construction phase, you typically make interest-only payments (or no payments at all, in some cases) based on your outstanding loan balance.
Disbursements to contractors: As you reach milestones for your project, you or the builder can request draw payments for completed work. An inspector must verify that the work was done (but inspectors don’t necessarily evaluate the quality of work), and a disbursement goes to the builder if all is well.
Temporary funding: Loans typically last less than one year, and you pay them off with another "permanent" loan. The construction loan typically ends once construction is complete. To retire the loan, you obtain an appraisal and inspection on the completed property and refinance into a more suitable loan.
Since construction loans have higher (often variable) interest rates than traditional home loans, you don’t want to keep the loan forever anyway.
There are two ways to handle the temporary nature of these loans:
- Apply for a new loan after building is completed. You will need to qualify as if you’re applying for a new mortgage. As a result, you need income and creditworthiness to get approved.
- Arrange both loans up front (also known as single-closing). This approach may minimize closing costs because you bundle the loans together. After construction, you would end up with a standard home loan (like a 15-year or 30-year fixed-rate mortgage). This may also be preferable if you aren’t confident about getting approved after construction.
Stages: You can use funds from a construction loan for almost any stage of your project, including purchasing land, excavation, pouring a foundation, framing, and finishing. You can also build garages, basic sheds, and other structures, depending on your lender’s policies.
Down payment: As with most loans, don’t count on borrowing 100% of what you need. Most lenders require that you put some equity into the deal, and they may require at least 20% down. You can, of course, bring money to the table, but if you already own land you can use the property as collateral instead of cash.
A Solid Plan
To receive a construction loan, you’ll need to qualify, just like with any other loan. That means you need good credit and favorable ratios (debt-to-income and loan-to-value). Consistent income also helps.
Lender approval: Construction loans are unique because the bank needs to approve your construction plans. If you’re buying from a builder that regularly works with a particular lender, approvals might be streamlined. However, "custom" projects can be challenging. Expect your lender to ask for complete details about the project: Who is doing the work, how exactly will it be done (architectural drawings should convey details), what’s the schedule for each phase, how much does everything cost, will the structure meet local codes and requirements, and how much will the property be worth at completion? Unfortunately, you can’t just wing it.
Can you do the work? What if you want to do all of the building work yourself? Unfortunately, that makes things even more difficult. Banks are hesitant to work with owner-builders. Banks fear that non-professionals have a better chance for delays and problems. Unless you’re a full-time professional contractor with years of experience, you’ll probably have to hire somebody else.
Plan for the unexpected: Having a plan is excellent, and having flexibility is even better. Construction projects are notorious for delays and surprises, so be sure to leave some wiggle room.
Don’t budget for spending every penny the bank is willing to lend, and don’t plan on moving out of your existing home the day after "projected" completion.