Qualifying for a Home Construction Loan

Aug 10, 2018, 10:42 AM | Robin Kocherhans
Construction Loan

Are you interested in building your own home?

If you want to get a mortgage to fund the new construction of your dream home, you might be surprised to learn that these types of home loans have significant differences compared to traditional mortgages.

What Is a Home Construction Loan?

A home construction loan is a unique type of short-term loan that is used just for new home construction and is different from a mortgage in the way it is paid out, the interest rate, the term length, and the ending balloon payment.

Right now you might be wondering what a balloon payment is. Basically, when the loan reaches the end of its term, the whole amount of the loan is due, so the payment basically balloons in amount.

Since most borrowers don't usually have that kind of money, they usually get a traditional mortgage loan and use it to pay off the construction loan.

How Is a Construction Loan Different Than a Mortgage?

A major difference between a home construction loan and a mortgage is the way the money is paid out to you or your home builder. The loan will be set up in a series or “draws,” which are scheduled times when a portion of the loan is paid out.

When the draws will happen is agreed on beforehand by the builder, the homebuyer, and the lender. So, for example, the builder might get 10% to start the job, 10% after the foundation is done, 10% after the framing is finished, and so on.

The lender will have someone inspect the house to make sure that construction is on schedule and done correctly before releasing the next draw.

Another difference is how the interest rate on a home construction loan is calculated. This rate is determined from the nationwide prime rate, plus an additional amount determined by your lender.

Basically, this means that a home construction loan will have a higher interest rate than a typical mortgage will. This happens because they are riskier for lenders, as there’s no physical house to back up the loan in case you don’t pay.

Also, construction loans are often interest-only, meaning you don’t pay off any of the principal. However, you only make your monthly payments on the amount that has been paid out in the draws so far. If only $10,000 has been paid out in the first draw, for example, you’d only pay interest on that.

How to Qualify for a Home Construction Loan

Since home construction loans are riskier for lenders than mortgages are, qualifying for one is more difficult. In order to qualify, you will need to be prepared with:

  • Good Credit and Income – You’ll need a good credit score, a good credit history, and a dependable source of income. Again, this type of loan is riskier, because it’s not backed by a finished house, so the lender will require more information about your personal finances.
  • A Down Payment – You’ll usually be required to pay 20% down, but it could be as high as 25%. This money serves as a buffer for the lender in case the house doesn’t appraise at the expected level after it’s constructed.
  • A Qualified General Contractor – Finding a great general contractor with a track record of building quality houses on time might actually be the most important decision you make during this process. Take your time, shop around, get recommendations, and so on, just like with any major purchase. It can also be beneficial if your contractor already has a good relationship with your lender.
  • Detailed Construction Plans – The builder should supply a construction plan to the lender that includes, at the very least, a floor plan and a list of construction materials. Or they might create a “blue book,” which is extremely detailed.
  • An Appraisal – This type of appraisal is an estimate of how much the finished house will be worth. It’s based on construction plans, comparisons to similar houses, and the value of the land.

Home Construction Loan Risks—And How to Minimize Them

One potential risk of getting a home construction loan is that it might cost you more than you expect. The builder might not finish on time or might go over budget. That can mean making payments on the loan for a longer amount of time or paying to rent somewhere else while you wait for the home to finish.

Another risk is that the house could be worth less than the appraisal suggested, either because of a change in the housing market or because of mistakes the builder made. For this reason, you should have a cash buffer large enough to get you through any of these situations. You might also want to borrow 5–10% more than the builder is charging, just in case.

There's also the risk that you don't qualify for a mortgage even if you qualify for the construction loan. This can happen if your credit score drops too far during the 4–16 months that new home construction can take, or if your income changes because of a layoff.

Because you still need to pay off your construction loan, even if you don't qualify for a mortgage loan, this can leave you on the hook for a lot of money.

One way to get around this problem is to qualify for a “construction-to-permanent” or “one-time close” loan, which means you only have to qualify once to be guaranteed that your construction loan will be converted into a mortgage at the end of its term. You can even get all the construction loan interest rolled into the final mortgage, so you don’t have to pay any of it during construction.

At Elevate Mortgage Group, we have experience doing one-time close loans, so we can help reduce this risk for you. Just make sure you talk to us at the beginning of the process.

Construction Loans Can Make Your Dream Home a Reality

If you have good enough credit, reliable income, and a large enough cash buffer, you might be in a position to qualify for a home construction loan and to get through the construction process in a financially responsible way.

Let Elevate Mortgage help you navigate through this process. Contact us today to talk with an expert loan officer about your home construction dreams.

Robin Kocherhans

Robin has been writing about mortgages for almost 2 years and has been a professional writer for 8. She loves researching and answering your questions about home loans and the mortgage process, as well as helping simplifying complex topics to make them easier for you to understand.