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Construction Loan: How Does It Work?

Construction Loan: How Does It Work?

Buying a house is a big decision, but building a home raises the stakes much higher. From choosing the best contracting company to fulfilling building codes to working out the mortgage payments, constructing a home can rapidly become a demanding undertaking. A construction loan can help you manage the financial aspects of your new residence. Read on to find out how a construction loan can help you on your home ownership journey!

What is a Construction Loan?

It is a short-term, high-interest loan that offers the funds necessary to construct a house and are normally provided for one year. During this period, the house must be constructed and an occupancy certificate should be issued.

How Does a Construction Loan Work?

Construction loans assist future homeowners to borrow money to buy construction materials and pay for labor. You can also use this money to buy the land on which you’ll be building. If the land is already yours, you might be allowed to utilize it as loan collateral. Construction loans are often given for a term of 12 to 18 months since they are meant to fund the building process. Nevertheless, after the building is completed, some loans automatically turn into permanent mortgages.

Unlike conventional mortgages, construction loans are not backed by a completed house. Furthermore, the application and approval formalities for a construction loan are more complicated as compared to a mortgage. Your lender will most likely want to review your architectural plans and analyze your financial status before authorizing funding.

If you are accepted for a construction loan, you will not get all of the cash at once. Instead, the lender will pay your builder in a series of draws, or installments, as they finish different phases of construction. Draws are planned according to the construction timeline, and your lender will most likely send an inspector to verify the progress of the building before each payment.

In most situations, you will only be obligated to repay interest on the funds as they are drawn, rather than the total loan amount. Depending on the lender, you may be able to turn your construction loan into a mortgage when the work is finished. If this is not a possibility, you could be able to repay your construction loan with a mortgage, often known as an end loan.

Types of Construction Loans

Just like ordinary mortgage loans, construction loans are varied. These are some of the types of construction loans:

  • Construction-only loans
  • Construction-to-permanent loans
  • Stand-alone loans
  • Renovation loans
  • End loans
  • Owner-builder loans

How to Get Approved for a Construction Loan?

The approval process for this loan is often more stringent than for a mortgage or any other loan because the construction loan will not be backed by or collateralized by a house. To get qualified for a construction loan, you will require:

  • A minimum credit score of 680 
  • Sufficient income to repay the loan
  • A low debt-to-income ratio
  • A 20% down payment
  • Project and construction budget approval
  • General contractor or builder approval

Still not sure if a construction loan is the best option for constructing your dream home? We’d be happy to help with all your questions. Contact us today!

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