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Are you ready to build your dream house? If so, the next step is figuring out how to pay for it.
A home construction loan may be a good option. These loans can give you access to the funds needed to build a home, and in some cases could convert to traditional mortgages after construction.
Let’s take a look at the different types of home construction loans and what it takes to get one.
- What is a home construction loan?
- How does a home construction loan work?
- How can I get a home construction loan?
- What if I don’t qualify?
What is a home construction loan?
Some home construction loans can help you finance the construction of your home, including everything from the land purchase to the construction itself. Construction loans are typically short-term loans that require borrowers to begin paying them back typically from six to 24 months after the loan is made, though this can vary.
Here are some different types of home construction loans to consider.
With this type of loan, you borrow money to build the home — and once construction is done, the loan converts to a traditional mortgage. With this scenario, you pay closing costs just once and you may be able to lock in a mortgage rate during the construction process, depending on the lender.
With a construction-only loan, you borrow money to build the home and pay any closing costs and fees associated with this loan. After construction, you may have to reapply for a new loan to pay off the construction loan. This requires a second closing process, and likely more fees.
Other types of home construction loans
In some cases, you can apply for a renovation home construction loan, which will let you borrow against the expected value of your home after the renovations. A home equity line of credit, or HELOC, can be another option to finance this type of home improvement project, as is a cash-out refinance.
Another type of home construction loan is referred to as owner-build construction. You would have to serve as the builder of the home as part of qualifying for this type of home construction loan.
How does a home construction loan work?
The process to get a home construction loan might differ from other types of loans you’ve had. Your interest rate is typically a bit higher than for a mortgage because of the risk involved to the lender.
Depending on the type of home loan you get, you may be able to lock in a fixed interest rate. As with any type of loan, the lender and specific terms you are approved for vary so be sure to familiarize yourself with the exact terms of your loan.
Additionally, a home construction loan requires planning among the lender, homebuilder and yourself. Generally, if you’re approved for the loan, you’ll work with your loan officer and the builder to set a timetable for the home’s construction.
This will help determine the number of distributions, or draws, from the loan that will be given to the builder to pay for various milestones during the construction phase. Depending on your lender’s terms, there may be a time limit on how long home construction can take.
How can I get a home construction loan?
Qualifying for a home construction loan can include strict requirements because the asset — in this case the finished home — doesn’t yet exist. As with a mortgage, you’ll likely need to pay closing costs for your home construction loan. Lenders will evaluate your loan application based on a number of factors, one being your credit profile.
Lenders look for good credit and a healthy debt-to-income ratio, which is the total of your monthly debt payments divided by your gross monthly income.
Because lenders may have strict underwriting criteria for a home construction loan, it’s important to check your credit before you apply. You also may need a hefty down payment, typically at least 20%, though this will vary based on your specific situation. Even if not required, it could be beneficial to make a larger down payment as a part of negotiating terms.
What if I don’t qualify?
If your application is denied or you decide you’d like to first work to improve your credit to potentially increase your odds of loan approval, keep the following tips in mind:
- Make timely payments on all bills, including loans and credit cards
- Pay off your credit card balances on time and in full every month
- Don’t open multiple new accounts at the same time
- Try to avoid closing any open credit cards, regardless of how infrequently you use them
If you decide to apply for a home construction loan, do your research to make sure the terms work for you. You’ll usually have to pay off the construction loan with a lump sum payment, convert the loan to a conventional mortgage or reapply for a new loan depending on the lender.