Everything You Need to Know about Construction Financing
First things first: what is construction financing?
Construction financing is a loan provided to build a home from the ground up. One of the great things about construction financing is that it allows clients to custom build a home exactly the way they want it. It’s often used when clients are building their dream home, or when they can’t find the style home they’re looking for on the market.
Building a home has always been a popular choice, but it’s rarely done by first-time home buyers. In fact, most of my clients taking out a construction loan are building their third or fourth home – because they’ve already built up equity in a property, have expanded their family or are simply now at a stage where they can invest more in their next home.
It’s important to know that construction loans are not used for rehabilitation, or “rehab” projects on existing homes. Instead, rehab loans are used for these projects, and we may focus on that topic in an upcoming post. But for today, we’ll tell you everything you need to know about construction financing.
How construction loans work
A construction loan works as a line of credit. This means that funds are advanced to your builder as the work is completed, rather than all at one time up-front. Interest only is paid monthly on the principal balance of the construction loan. For reference, the average home takes four to six months to build (a custom executive home can take as long as a year) so the line of credit – your construction financing – would remain in place throughout the entire building period.
However, a construction loan is not revolving. This means that the funds are only available to borrow one time.
How is construction financing different than a traditional mortgage?
Approval for a construction loan is often no more complicated than a traditional mortgage. The loan works as a line of credit, which is in place for the time that the home is being built. After the home has been completed, the construction loan transitions from a line of credit (a short-term loan) to your permanent financing, often either a 15-year or 30-year fixed mortgage.
The underwriting process for construction financing is also the same as it would be for a permanent loan. At Bankers Trust, we’ll look at your income, credit score, debt-to-income ratio and other factors, just as we would for any other home financing. In many cases, if you are approved for a mortgage loan, you will be approved for a construction loan as well.
On the other hand, there are differences you should be aware of before pursuing a construction loan. Some of these include:
- Down payments can be as low as 10 percent for homes valued at $550,000 and less. While permanent loan financing options can offer down payments as little as 3-5 percent, the minimum for a construction loan down payment is often higher, due to the investment in building a brand new home.
- Interest rates are typically lower for construction financing than permanent loan rates.
- Typically, you will only pay one set of closing costs throughout the process. Depending on project size, you will only pay closing costs when you close on the construction loan, and additional closing costs when the loan transitions to permanent financing will not be required.