Traditional loans are readily available, but are often held: You can only borrow money to buy an existing home. A loan for a building differs in that it finances everything needed to build a new home, garage or business building. They can also work when repairing or buying land (if you are not yet the owner of the property you need).
How Construction Loans Work
A mortgage loan is a temporary loan for real estate. You can use the loan to buy land, build on existing land, or renovate existing buildings if your plan allows. A construction loan is similar to a credit line because you only get the amount you need (in an advanced way) to complete each part of the project.
As a result, you pay interest on the loan only more than the total loan amount, where you take 100% of the advance payment and pay interest on the entire balance immediately.
During the construction phase, you usually only pay interest (or no payment at all, in some cases) based on your outstanding loan balance. Typically, payments start six to 24 months after receiving the loan.
As you progress and reach the tops of your project, you or the builder can request drag payments for the finished work. The inspector should make sure that the work is done, but the inspectors do not really check the quality of the work. Payment goes to the builder if all is satisfied.
Construction loans are usually short-term loans and are usually repaid with another “permanent” loan. Construction loans usually expire once construction is complete. To stop borrowing, you get an appraisal and a site inspection completed and re-funded into a proper loan.
There are two ways to handle the temporary nature of these loans:
Apply for a new loan after the completion of the construction process. You will need to qualify as if you were applying for a new loan. As a result, you need income and credit to be approved.
Set aside both debts at the beginning of the process (also known as single closure). Another name given to FHA is a mortgage-to-construction mortgage. This method may reduce the cost of closure because you combine loans together. After construction, you will end up with a standard loan (such as a 15 or 30 year interest rate loan). This can also be good if you are not sure of the approval after construction.
You can use the proceeds from a loan to build almost any phase of your project, including land acquisition, excavation, foundation, framing, and finishing. You can also build garages, basic sheds, and other buildings, depending on your borrower’s policies.
Like most loans, do not rely on borrowing 100% of what you need. Most lenders require you to put a certain amount in the deal, and they may require a reduction of at least 20%. You can, of course, bring money to the table. But if you already own the land, you can use the property as collateral instead of money.
To get a construction loan, you will need to qualify, just like any other loan. That means you need good credit and reasonable rates (income and borrowing value). A 20% lower payment is also commendable, although there are exceptions to this. Proof of consistent income is also important.
A mortgage loan is different because the bank must approve your building plans. If you buy from a builder who regularly works with a lender, authorization may be easier. However, “custom” projects can be challenging.
Expect your lender to ask for full details about the project, including:
- Who does the work?
- How to do it (building drawings should convey details)
- What is the schedule for each phase?
- How much does it all cost?
- Will the building meet local codes and requirements?
Can You Do the Work?
What if you want to make a whole building for yourself? Unfortunately, that only makes matters worse. Banks are reluctant to work with owners-builders. Banks fear that non-professionals have a better chance of delays and problems. Unless you are a full-time contractor with years of experience, you will need to hire someone else.
Having a plan is great, and being flexible is even better. Construction projects are notorious for delays and surprises, so make sure you leave room for movement in your budget and timeline.