Seems like a pretty easy question to answer right? A construction loan is a loan that pays for the construction of your home. However, it's not always as simple an answer as that.
Types of Construction Loans
There are many different types of construction loan programs available out there. You’ll want to research what’s available to you and what makes the programs different from one another, before deciding what lender to pursue the loan with. The two main types of construction loans that you’ll see most often are Construction to Permanent Loans and stand-alone Construction Loans.
A Construction to Permanent loan starts off as a construction loan and automatically converts into a 15 or 30 year or Adjustable Rate Mortgage once the building is complete. You’ll have only one closing process and one set of closing costs to pay. Typically, you’ll lock in your mortgage rate when construction begins, depending on the lender’s program. This is especially helpful in a rising rate environment when mortgage rates are going to be lower when you start building than when your construction phase is completed. Some Construction to Permanent Loans cover the cost of purchasing land and some will require that you already own the land for at least a month before proceeding with the loan.
A stand-alone Construction Loan is only a construction loan. Once construction is finished, the loan will need to be paid off. This is where a mortgage loan comes in. You’ll need to take out the mortgage to pay off the construction loan. You’ll have two loans to apply and qualify for, two sets of closings and two sets of closing costs and fees. You also aren’t able to lock in a mortgage rate during construction. It will have to wait until you apply for the mortgage loan at the end of construction.
What happens during construction?
A Construction Loan doesn’t pay you in one lump sum once you sign off on it. Instead, it is paid in installments, or “draws”, to the builder. The draw usually goes along with the completion of important milestones during construction, such as pouring the foundation and framing. An inspection is required before a draw is made to the builder and the amount of the draw will depend on the work completed.
Your payments during the construction process will be based on the amount of the loan already disbursed. All programs differ so be sure to do your research before signing off, but as an example, HFS offers up to 12 months of interest only payments during construction. This means you’re paying interest only on the amount of money drawn. Each time a draw is made, your payment will go up.
This all sounds great, how do I qualify?
When you take out a mortgage, the home is the collateral for the loan. However, with a construction loan there is no home yet, which means no collateral to back up your loan. For this reason, it can take a little more effort to be approved for the loan.
Your lender will want details about the house you plan to build and the contractors you plan to use to build it. Some lenders may even have a list of approved or recommended contractors which can help you make your decision as you plan to build. As with any loan, the lender will also want to thoroughly review your finances to ensure that you’ll be able to keep up with your Construction Loan payments as well as your other loan payments during the process.
Building a home can be a tedious process, however, by taking the time to research your options and talk with lenders to discuss your options, you can take some of the stress out of it. Your primary financial institution is a great place to start with any questions.
HFS has a Construction to Permanent Loan product available, which you can learn more about by visiting our helpful product page. Give us a call at (808) 930-1400 if you’d like to make an appointment with a Loan Officer to discuss your options.
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