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What are Construction Loans & How Do They Work?

New residential construction home framing against a blue sky. Roofing construction. Wooden construction

Construction Loans are a type of loan that allows you to finance the development and construction of a building or home. This is the type of loan you’d need if you want to purchase property or land and build. Real estate is anything but stable today, but don’t let fluctuations in the market deter you from building a home you love. Though it may not be the best time to sell or buy, building a home might be the perfect solution with the help of a Construction Loan.

Read on to learn everything you need to know about Construction Loans – from what they are, to what types are available, to what you need to qualify and get started.

What is a Construction Loan?

A Construction Loan is a short-term – generally 1 year – type of funding used to finance the development and construction of a new home or commercial building. Borrowers use Construction Loans to pay for the materials and labor costs associated with the building before obtaining a traditional, long-term mortgage once the home is built.

At that point, a Construction Loan can either be refinanced into a traditional mortgage or paid off with another loan. Here at HFS we have a Construction to Permanent Loan product designed to start off as a Construction Loan and roll into a First Mortgage when building is complete. Your First Mortgage rate gets locked in at the time you begin construction.

Construction Loans can cover the following:

  • Cost of land (in some cases)
  • Building materials
  • Labor (contractors)
  • Permits

How Do Construction Loans Work

A homeowner or builder takes out Construction Loans to fund a project as it’s built. Borrowers pay interest on Construction Loans until the building is complete, at which time final payments are made. You can get a Construction Loan through the following general process:

  • To apply for a Construction Loan, a borrower must submit financial information, project plans, and an overview of the anticipated timeline.
  • Upon approval, the borrower has access to funds according to each defined project phase.
  • Generally, a borrower will only repay interest on the loan throughout the construction phase.
  • The build is assessed by an inspector (or an appraiser) during the construction.
  • They will authorize more funds to be released throughout the duration.
  • Construction Loans can typically convert to a more traditional, permanent mortgage loan upon completion of construction.
  • The borrower will begin paying back the principal and interest on the total loan amount at this time.

The most significant difference between a Construction Loan and a traditional mortgage or personal loan is that you pay back principal plus interest with a conventional mortgage or personal loan. In contrast, with a Construction Loan, only interest is paid back during the repayment period, which lasts until the completion of the project.

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.

Construction-to-Permanent 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.

Stand-Alone Construction 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.

Construction Loan Qualifications

The qualifications for a Construction Loan are slightly different from those of a traditional mortgage. If you’re looking to buy a house or refinance your current home, the lender will look at your credit score and history of paying off loans on time. They’ll also want to see that you have enough money in savings to cover the down payment and closing costs associated with buying the house.

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.

So what exactly does it take to qualify? Here’s what you need:

  • A “good” credit score (680+)
  • A detailed budget showing how you spend money each month and how much income comes in each year (if self-employed)
  • Down payment of at least 20-25%
  • Low debt-to-income ratio
  • Proof that you can afford the monthly payments after the completion of construction
  • Blue Book of construction plans and contractors
  • Length of credit history

Construction Loan Interest Rates

Construction Loans are interest-only loans. The borrower only pays the interest on the loan and repays this portion when they close out the loan. This is why Construction Loans have higher rates than traditional mortgage loans.

However, a few factors can help lower what it costs you to borrow. First, having good credit is always a plus. A sizable down payment can also be beneficial.

Currently, rates range around 5%-10%, and they’re usually about 5% more than the rate on a traditional mortgage might be.

How to get a Construction Loan Started

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.

You need to take a few steps before you’re ready to begin construction:

  • Get pre-approved for a Construction Loan
  • Apply for a Construction Loan
  • Sign the Construction Loan Agreement
  • Get Your Construction Draw and Disbursement of Funds (or at least know when they will be coming)

HFS Construction to Permanent Loans are tailored to fit your financing needs. Build the home you’ve always dreamed of with a financial partner you can count on. HFS Construction Loans offer the convenience of:

  • Locked in interest rates
  • 12 months of interest-only payments
  • Access to up to 80% of appraised value
  • Convert automatically to the traditional mortgage of your choice (15 or 30 year)

Download the documents and information necessary to get started today. HFS offers everything you need to build the home of your dreams.

Learn more about Construction to Permanent loans – or give us a call at (808) 930-1400 if you’d like to make an appointment with a Loan Officer to discuss your options.