ShareFinding the perfect home isn’t always easy, especially when clients are particular about their desired location and home style. Sometimes, the best option for a client may be to build a home that’s tailor-made to suit their needs. A construction loan can help your clients finance the construction of their dream home. A well-prepared real estate agent can support a buyer through this process, helping them find the right lender and choose the right loan.
Let’s review types of construction loans, their benefits, and how real estate professionals can advise clients to use them to build a home.
How Do Construction Loans Work?
A construction loan is a short-term loan that provides borrowers with the funds to construct a home. Construction loans are disbursed in a series of installments to cover costs as construction progresses. A construction loan can be used to cover multiple costs associated with building a home, including land, labor, building permits, and materials. Borrowers start repayments on a construction loan within six to 24 months after the loan is issued.
Borrowers may repay the balance all at once (lump sum) or convert the loan to a mortgage loan. If the lender does not offer the option to convert the loan, qualified agents can help their clients find a mortgage lender willing to issue a new loan for a refinance. When the time is right, you can support your clients by helping them compare loan terms and rates. Real estate agents can benefit from understanding loan types so they can help clients unlock financial pathways.
Difference Between a Construction Loan and a Mortgage
Construction loans are different from mortgage loans in many ways, such as disbursal, interest rates, and repayment terms. Here are a few key differences between these two types of home loans.
- How it’s used: A mortgage is used to purchase an already-built property, whether it's a single-family home or condo. By comparison, a construction loan, also known as a self-build loan, is used to finance the construction or renovation of a property.
- Repayment terms: Mortgages are typically long-term loans with repayment terms generally between 15 to 30 years. Construction loans are short-term loans with a fixed term, often around one year, aimed at covering the period of construction.
- Repayment process: Soon after receiving their mortgage funds, traditional mortgage borrowers begin making regular monthly loan payments that include both principal and interest. With construction loans, borrowers often make interest-only payments while their house is being constructed. After construction, the loan can be converted to a permanent mortgage, and regular mortgage payments, including both principal and interest, begin.
- Interest rates: Mortgage borrowers can typically choose between fixed or adjustable interest rates. However, construction loan rates are usually variable and can change over the life of the loan based on market fluctuations.
- Disbursement of funds: With a mortgage, the entire loan amount is disbursed at the time of purchase. Funds from a construction loan are disbursed in installments to cover the costs of construction in phases.
- Loan approval: Mortgage lenders tend to focus mainly on a borrower's creditworthiness, income, and debt-to-income ratio. However, construction loans have additional requirements, such as detailed construction plans, budgets, and project timelines.
Types of Construction Loans
Lenders offer a few different types of construction loans with specific purposes. As a real estate agent, it can be helpful to understand the different types to best advise your client.
Construction-to-Permanent Loans
Loans that initially finance the construction of a new property and are later converted to a permanent mortgage are known as construction-to-permanent loans. Borrowers initially receive funds to cover construction costs. After construction is complete, the loan can be converted into a traditional mortgage, FHA mortgage, or VA mortgage depending on the client's eligibility. Borrowers pay closing costs just once and can choose between a fixed or adjustable-rate mortgage.
Stand-Alone Construction Loans
Stand-alone construction loans are used to finance the construction of a property. Borrowers receive funds to cover the construction phase but will need to secure a separate permanent mortgage to pay off the construction loan once the project is finished. Since this type of borrowing structure includes two separate loans, it carries two sets of closing costs.
Renovation Construction Loans
Renovation construction loans are designed to help finance significant renovation or improvement projects on an existing property. Funds from these loans are used to pay for the renovation or remodeling of an existing structure. Agents may recommend a renovation loan to buyers who are interested in a fixer-upper– a house that would require major work to make it livable.
FHA 203(k) Loans
FHA 203(k) loans are a type of renovation loan insured by the Federal Housing Administration. Also known as a mortgage rehab loan, this loan funds both the purchase and renovation of a home. It's technically a type of mortgage which sets it apart from other construction loans. FHA 203(k) loan minimum down payment requirements can be as low as 3.5%.
Owner-Builder Construction Loans
Owner-builder construction loans are great for buyers who intend to act as the general contractor for their own construction project. This type of loan enables appropriately qualified or experienced home buyers to build or renovate their own homes as long as they can manage the construction project.
What Are the Benefits of Construction Loans?
Construction loans offer some notable benefits to buyers who can’t find a house they like. Consider some of the advantages listed below:
- Since borrowers pay only interest while the house is being constructed, they don’t need to worry about higher monthly payments right away.
- Construction loans are issued based on the future value of the property rather than the current value. This appraisal style enables borrowers to access the funds they need for the project.
- Construction loans come in different forms to suit different clients. Flexibility is a major advantage of this type of loan since they can be leveraged for new builds or remodels.
What Are Some Construction Loan Requirements?
Buyers must meet their chosen lender's eligibility criteria to obtain a construction loan. While good credit, an adequate income, and a low debt-to-income ratio are essential factors, lenders may also consider construction plans and budgets. Review a few of the most common criteria considered by lenders when assessing construction loan eligibility.
- Borrower's creditworthiness: Lenders may require a high credit score for home construction loans compared to mortgages. A good credit history with no late payments and derogatory marks could help improve your client’s odds of approval.
- Down payment: As with a traditional mortgage, lenders won't finance a project completely. Borrowers need to provide a down payment to facilitate approval. Down payment amounts vary based on the lender, the property, and the type of loan in question.
- Low debt-to-income ratio (DTI): A low DTI indicates that the borrower is not already in deep debt and can afford the payments.
- Construction paperwork: This could include a purchase offer or deed, construction schedule or timetable, construction contract with your builder or developer, itemized budget, and building plans. These documents demonstrate an applicant's preparation for the project and their ability to effectively manage it within the construction loan term.
- Compliance paperwork and permits: The lender may want assurance that the construction meets all the relevant zoning laws and that buyers have obtained the necessary permits.
- A well-qualified team: Providing evidence of the builder and architect's qualifications may also help with approval. The builder's insurance certificate, financial statements, resume etc., may be good additions to the application. It's a good idea to provide a list of personnel (architect, builder, contractor, etc.) and provide a list of each party’s responsibilities.
Leveraging Construction Loans for Success
Most construction loans have many benefits for clients, and real estate agents can provide support at various points during the process. They can support clients in identifying the right plot of land, putting together a team of experts to manage construction, understanding and choosing a construction loan, and finally converting the construction loan to a traditional mortgage. To provide effective guidance, it’s important for real estate agents to incorporate a working knowledge of construction loans into their practice and continue learning about them over time.