When it comes to financing new home construction, doing your own research and educating yourself on what goes into it can be extremely beneficial. For one thing, you’ll know what to expect, and for another, you’ll be more equipped to deal with the tough financial questions before they come up. Many homeowners are unable to pay for a custom-built home with their own money, so it’s quite common for homeowners to look for alternative forms of financing. Understanding an investment such as a custom home is one of the best things you could do for yourself as a prospective homeowner. Today, we will be demystifying construction loans, and talking a bit more about a few other loans you may learn about in your home building process. 

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What is a Construction Loan?

We talked a little bit about construction loans in a past blog about financing your custom home build, but today we are going to do a deep dive. A construction loan, also called a “self-build loan,”  is a short-term loan that covers only the costs of custom home building. The home buyer will take out a construction loan to cover the costs of the project before obtaining long-term funding. Because construction loans are considered risky, construction loans usually have higher interest rates than traditional mortgage loans. 


Why Are They Considered Riskier?

With a traditional mortgage, your home acts as collateral, and if you default on your payments, the lender can seize your home. With a home construction loan, the lender doesn’t have that option, so they tend to view construction loans as a bigger risk. Furthermore, because construction loans are on such a short timetable and are dependent on the completion of the project, you need to provide the lender with a construction timeline, detailed plans, and a realistic budget.


What Do Construction Loans Cover?

Generally, construction loans won’t be paid to the borrower. Instead, the funds go directly to the builder or general contractor as needed. These funds can be used for all of the costs related to the project, including permit costs, materials, labor, and other expenses. Construction loan funds can only be used for the building of your home. Don’t expect to be able to use any leftover money to furnish your new home.


How Construction Loans Work

Construction loans are typically taken out by the builders or the homebuyer that is custom-building their home. They are short-term loans that are usually for a period of only one year. After the construction of the house is complete, the borrower can either refinance the construction loan into a permanent mortgage or obtain a new loan to pay off the construction loan, which is sometimes referred to as an “end loan.” 

The borrower might only be required to make interest payments on a construction loan while the project is still underway. Some construction loans may require the balance to be paid off entirely by the time the project is complete. 


How Are Construction Loans Paid Back?

Construction loans are usually short and are dependent on the appraisal, which is why it’s important to work with an experienced and trustworthy builder. Over the course of construction, you will only pay the interest on the loan rather than any money that goes towards the principal. Once construction is completed, the remainder of the principal will be transitioned into your permanent mortgage and be paid over whatever length of time is agreed upon between you and your lender.


How is the Builder Paid

The builder is paid according to a structure set ahead of time through disbursements called draws. Essentially, this is just how you might pay a builder if the money was coming straight from your bank account. The builder will be paid out upon completion of different major elements of the process such as framing, plumbing, etc. Once the house is 100% complete, the builder will have been paid all the way that they were promised for their work. This is when your loan converts to a permanent loan, and you begin paying the bank back on the money that they have dispersed to the builder throughout construction. Basically, you are starting a new loan so that you can pay back the construction loan.


Types of Construction Loans

Construction-to-Permanent Loans

Construction-to-permanent loans provide the funds for your custom home construction before converting to a permanent mortgage when building is complete. With a construction-to-permanent loan, you borrow money to pay for the cost of building your home, and once the house is complete and you are all moved in, the loan is converted to a permanent mortgage.

The benefit of this approach is that you only have one set of closing costs to pay, which reduces your overall fees. Once it becomes a permanent mortgage, with a typical loan term of 15 to 30 years, then you make payments that cover both interest and the principal. During this time, you can opt for a fixed-rate or adjustable-rate mortgage.


Construction-Only Loans

A construction-only loan provides the funds necessary to complete the building of the property, but the borrower is responsible for either paying the loan in full at maturity or obtaining a mortgage to secure permanent financing. The funds from these construction loans are disbursed based upon the percentage of the project completed, and the borrower is only responsible for interest payments on the money drawn.

These loans are almost always tied to the prime rate and a margin. Because of this, they tend to have a higher rate than traditional mortgages. Construction-only loans can ultimately be costlier if you will need a permanent mortgage because you complete two separate transactions and pay two sets of fees. 


Renovation Construction Loans

If you want to upgrade an existing home rather than build a new home, you can look for a renovation loan, which comes in a variety of forms depending on the amount of money you’re spending on the project. With renovation construction loans, the cost of major renovations is wrapped into the mortgage instead of financed after closing. The loan is based on the home’s value after repairs and renovations. These loans make sense if you are buying a fixer-upper and don’t have cash for renovations. 

Another option is a cash-out refinance, in which the homeowner takes out a new mortgage at a higher amount than their current loan and receives that overage in a lump sum. This is another effective, affordable way to tap your home’s equity to improve your property. 


Owner-Builder Construction Loans

Borrowers who intend to act as their own general contractor or build the home with their own resources are unlikely to qualify for a construction loan. Instead, these borrowers will have to take out a variant called an owner-builder construction loan. It can be difficult to qualify for these loans, but a well-researched construction plan that convincingly lays out their home-build knowledge and abilities certainly helps. 


How to Get a Construction Loan

As with all mortgages, the minimum credit score, maximum debt-to-income ratio, and down payment required for a construction loan will vary from lender to lender. In most cases, these requirements are based on the amount of money you borrow. Lenders will review your debt-to-income ratio, credit score, down payment, and repayment plan, as well as your construction plan and schedule. 

Since there is no physical house available for collateral with a construction loan, excellent credit is key. Many lenders also require a 20% down payment for a construction loan, and no lender will approve a loan unless they are confident the borrower can make the monthly interest payments during construction. 


Final Thoughts

Getting yourself ready for a custom-built home takes a bit more work than you may have originally thought, and a lot of up-front leg work, like getting your finances together. If you are looking to build a custom home, you’ll need to obtain both a construction loan and a permanent loan (mortgage). 

The construction loan is a short-term loan that finances the construction process by paying draws to the builder as designated milestones are completed. Meanwhile, you will only pay a down payment along with the interest payments. The construction loan then converts to a more standard permanent mortgage loan once construction is finished, at which point you’ll begin paying back the lender on the total for the entire home (principal and interest).

To learn more about the custom home building process, or to gain more insight into how you can finance your custom home, contact the custom home builders at Splittgerber Professional Builders in Fort Collins. We are happy to serve the northern Colorado community and consider it a privilege to work with you to create your dream home. Give us a call today.