Many people think about building their dream home someday. If you want someday to come soon, it may be time to start considering a construction loan. Construction loans are different from typical mortgage loans, though, and it’s important to understand how they differ. Here’s a brief overview.
If you're new to buying a home, you may just be thinking about getting a mortgage loan. A mortgage is a loan on an existing building. If you want to get funding to build your dream home; however, you need to apply for a construction loan.
Construction loans usually cover the costs of land, permits and fees, plans, labor and materials, and closing costs. Not all lenders offer construction loans, so you will need to find one that does.
Construction loans are usually granted for a specific amount. Specific portions of the amount are given to the builder during the process, upon completion of certain parts of the home. The portions are known as “draws.” Your contractor, for example, may get the first draw to start the foundation and the second upon completion of it. The lender may inspect the progress before the next draw.
During the construction period, borrowers are usually responsible only for interest payments on the construction loan. Most construction loans are converted to mortgages once the home is completely built. Once construction is finished and you convert to a mortgage, your mortgage payment will include principal, interest, and property taxes.
Construction loans are more involved than mortgage loans, for several reasons:
- First, lenders view them as slightly more risky. As a result, construction loans often have higher interest rates and shorter terms. Why? If you default on mortgage payments, the lender has the house as collateral. But if you default on a construction loan, the lender has only a partially built house.
- Second, there are more people involved in a construction loan. A mortgage loan takes place between your lender and you. A construction loan adds a third person: your contractor. The lender will scrutinize both your ability to pay and the contractor’s ability to complete the job on time and successfully.
- Third, construction loans often come with time constraints. Many require construction to be completed within 12 or 18 months and for a certificate of occupancy to be obtained when construction is done.
The approval process for a construction loan can be lengthy, because there is more for the lender to review than there is for a mortgage loan.
You will have to provide lenders with proof of income (your salary), bank statements, employment history, proposed down payment, and your credit score and credit history, just as you do for a mortgage. You may also have to show proof of additional cash reserves, as new construction sometimes sees delays and cost overruns.
Also be prepared to provide plans, specifications, and blueprints for your house. You can get a construction loan for all parts of the house, including the outside grounds.
Your contractor or builder will have to provide a budget based on the plans, specifications, and blueprints. Lenders may also require the builder's financial information, such as profit and loss or cash flow statements, length of time in business, licensing, and other documents.
Lenders will review your application for proof that you will be able to pay both the construction loan and the mortgage. They will review the plans and the contractor’s information to see that the proposed budget is reasonable for the house and that the contractor has successfully built houses before.
It’s a very good idea to get pre-approved for a construction loan before getting too far along in the planning process. You don’t want to pay for plans, specifications, and blueprints if you will not ultimately be approved for the loan.
Making the Decision: Considerations To Think About
As with all housing decisions, consider several factors when applying for a construction loan:
- Can I afford a construction loan and mortgage? Interest rates are currently at historically low levels right now. You should work with a lender on budget projections to make sure the payments for both the construction loan and mortgage will fit comfortably in your lifestyle now and in the future.
- Is my income/employment stable? If you lose your job or suffer a decline in income, you may not be able to obtain a mortgage (after the construction is complete). You want to make sure you can make payments over the 15 to 30 year life of a mortgage.
- Do I have enough cash reserves to cover delays or cost overruns? Homebuilding often takes longer and costs more than initial projections indicate. It’s prudent to plan for the possibility.
Benefits of Working with A Community Bank
At CBC Bank, you'll work with a fellow member of your local community – whether you're in Valdosta or the greater South Georgia region. We’ll take the time to get to know you, your plans for your dream home, and your financial situation. We’ll discuss your long-range goals and your lifestyle.
Working with a community bank can help you understand the steps and options available in construction and mortgage loans. We will work with you to make the entire process what it should be – the realization of a dream.