If you are building your own home, you’ll need help with the financing. Because you cannot take out a standard mortgage without a home to live in, you’ll need a construction loan. This loan provides temporary financing to help you fund the cost of building the home. Once the home is complete and livable, you will need to refinance the loan into a permanent mortgage.
Many lenders offer a construction-permanent loan, which is both loan options in one. In other words, you have one closing, yet the temporary mortgage for the construction financing automatically transfers into the permanent mortgage for you. There aren’t two closings to deal with or two sets of closing costs to pay.
No matter which option you choose, you’ll have to qualify for the construction loan. Keep reading to see what requirements you must meet.
The Construction Loan Requirements
Lenders take a big risk when they give you a construction loan. They are funding a home that is not even started. They are relying on the builder to be prompt and efficient while building a quality home. That’s a big risk for them to take. In order to make up for those risks, the lenders usually require the following:
- You must provide detailed blueprints that show every detail of the home and what the building process will entail. Alongside the blueprints, there must be a list of supplies necessary to complete the project so the bank has a full picture of what you will need.
- You must have a licensed and insured builder that the lender can approve. The builder must be able to prove his credentials to the bank, including his past experience in building homes.
- You’ll need a large down payment. It’s not unusual for lenders to require at least 25% down on the home. This gives you a little ‘skin in the game,’ and helps to take some of the pressure off the lender.
- You should have good credit. Each lender will vary on the requirements for the loan itself, but having a high credit score is usually a high priority. A high credit score shows lenders that you are financially responsible, which is important when you are building a home.
- You should have a low debt ratio. Again, lenders need to know that you are financially responsible. Building a home when you are already financially strapped each month is a recipe for disaster. Lenders prefer lower debt ratios to ensure that you have the cash flow to make the building process work.
The Inner Workings of the Construction Loan
When you close on a construction loan, you don’t have a seller to hand the money over to; instead, the money goes into an escrow account. The lender then manages the money as previously determined in the contract with the builder. Usually, lenders give an initial disbursement to help the builder get the necessary materials and get started.
The lender will then disburse funds on the designated draw dates. These are pre-determined dates that are outlined in the contract. The builder agrees to receive disbursements on these days as long as he has the work done to the point that is agreed upon in the contract. The amount of the disbursements depends on the agreement between the lender and the builder at the time of the contract.
The Permanent Mortgage
Once the home is complete and all disbursements are made, the permanent mortgage begins. Here is the difference between the temporary and permanent mortgage:
- The construction portion of the loan requires only interest payments. You do not have to pay any principal during this time. This alleviates the heavy burden of a mortgage, giving you money to live elsewhere while your home is being built.
- Once the loan turns permanent, you begin making principal and interest payments, just like you would on a standard mortgage.
If you decide to take a construction loan and wait to find permanent financing closer to when the home is finished, make sure you watch your financial life carefully. For example, don’t make any large purchases, open new credit, or pay your bills late. Any change in your credit score, debt ratio, or employment status could leave you without a loan to buy the house once it is built.
The construction loan is a great way to build your own home rather than buy a cookie cutter home from a builder. But, you have to be prepared for the extra work and risks involved in the program. If you can make it work, it’s a great way to build your own home. Just make sure you are aware of the pitfalls and that you talk to your lender about the opportunity to secure a construction-permanent loan.Click to See the Latest Mortgage Rates»