As a prospective homebuyer, you might be considering building a new home instead of purchasing an existing one. If you decide to build a new construction home, it is critical to do your research and find the construction loan that will best fit your individual financial situation.
There are several different types of construction loans available today for new homebuyers. Read on for more information about the most popular types of new construction loans and discover which is best for your project.
A “construction-to-permanent” loan, also referred to as a single-close loan, serves as an all-in-one package for homebuyers looking to build their dream home from scratch on their own lot.
A new construction home project usually requires two separate loans: a construction loan to finance the lot purchase and building of the house, then a regular mortgage to pay for the finished home. However, a construction-to-permanent loan finances the costs to buy the land and build the house, then rolls into the mortgage on the home once construction is completed. This means one single loan transaction for the entire project.
The major benefit of construction-to-permanent loans is that you will have only one set of closing costs, thus reducing your overall fees.
Once approved for a construction-to-permanent loan, borrowers may draw upon the funds incrementally as they would a line of credit. As the project progresses, they may draw only the funds needed for each phase of the project and pay interest only on the funds drawn during the construction stage.
Borrowers may utilize the benefits of the construction phase of the loan for up to 18 months, which is ideal in the event of a setback due to inclement weather or supply chain shortages.
Once your new home is ready for move-in, the construction loan is converted to a permanent fixed-rate mortgage, typically with a term of 15 to 30 years. Mortgage payments may cover both the interest and principal.
There are a few drawbacks to the construction-to-permanent loan. For one, fewer lenders offer this type of financing. Homebuyers who are interested in this loan may want to do their research in advance of contacting lenders and be prepared to answer every question about the investment. This may include where the home will be located, the size, design, and builder information, along with drawn plans and permits.
Lenders that offer a construction-to-permanent loan usually charge hefty, fixed interest rates during the building phase. The fixed interest rate may decrease when the loan converts into a permanent mortgage, but it could also stay the same. There’s a chance that you could be making interest-only payments for up to 18 months before you begin making interest and principal payments on the mortgage.
Construction-to-permanent loans also typically require a sizable down payment (20 percent is common). Lenders may also require extensive documentation of the construction process from start to finish, including reports every time money is drawn for the project. Some lenders require inspections at predetermined stages of the construction timeline, which will be paid by the borrower. Lastly, if the loan amount is not enough to cover the land and construction costs, the borrower is responsible for the out-of-pocket expenses.
A construction-only loan provides only the funds necessary to purchase the lot and complete the building of the home. This is meant to be a short-term loan that is issued for approximately one year to cover the construction period only.
This type of loan is suitable for homeowners who are selling their current home and plan to use the sum as a down payment for construction. By choosing a construction-only loan, homeowners can compartmentalize the construction financing and the permanent mortgage by maintaining them as two separate transactions.
Unlike the construction-to-permanent loan, the construction-only loan typically requires homebuyers to either pay the loan in full at maturity or obtain a mortgage to secure permanent financing. Because the construction loan and the traditional mortgage are separate, homeowners are responsible for two application processes and two closings. This can become costly, as you will pay two separate loan transactions and processing fees.
This loan is suitable for buyers who have a large sum of money on hand or who plan to sell their house to cover the construction costs for their new custom home. If homeowners have the means to pay off their construction loan using savings or their liquid assets from selling their home, this is a viable option.
Owner-Builder Construction Loan
An owner-builder construction loan is suitable for homeowners who act as their own general contractor and oversee the construction process of building their very own custom home.
In the case of an owner-builder construction loan, the borrower also serves as the home builder. Homeowners may have a little more freedom in how they complete the construction budget and fully utilize the loan balance. However, they are still responsible for providing updates and progress statements to the lender as requested and abiding by the terms of the loan as agreed upon.
The owner-builder construction loan is intended for use by individuals who wish to act as their own general contractor rather than hire a builder to manage the project. These types of loans may be hard to come by and will usually require an extensive application process. Loan approval is limited to individuals with proven experience as a home builder with sufficient education and licensure.
Hard Money Construction Loan
Hard money construction loans are short-term, nonconforming loans used to finance real estate investment property. They tend to have a less strict approval process and borrowers can be approved within a matter of days. However, there are a few reasons to be wary of these construction loans. Hard money construction loans tend to be riskier and often have a higher interest rate than other types.
While conforming loans have more stringent rules and processes, nonconforming construction loans are not confined by these rigid guidelines that can draw out the application and approval process. As such, you won’t find a hard money construction loan through a typical bank or mortgage lender. They are usually independent companies or private investors.
Lenders of hard money construction loans can usually make their own rules regarding acceptable credit scores and can set the interest rate as they see fit. Loan applicants that have been denied a traditional mortgage may qualify for a hard money construction loan because lenders are looking more closely at the value of the property rather than the borrower’s ability to repay the loan. If the borrower cannot repay the loan, the lender has the right to seize the property as collateral.
The barriers to entry are generally much lower than a traditional loan because lenders base their approval on the value of the property rather than the borrower’s financial history and credit report. The approval process for this type of loan takes a matter of days, making it suitable for developers with projects on specific deadlines that need to be met because the funds are available much quicker. They are also ideal for house flippers who work on a tight timeline, typically less than a year, for a short-term project.
The low barrier to entry and less rigorous approval process means greater risk to the lender, thus translating into higher interest rates. Hard money construction loans tend to be expensive and have a shorter time frame to repay. Additionally, they often require large down payments, and the lender will use the property as collateral to secure the loan.
Choose the Loan that Works for You
Choosing a new construction home has many benefits, including customizable options to fit your exact needs and preferences, and there are many different types of construction loans available for a variety of home design projects.
Homebuyers and builders should do their research and survey all options before making an informed decision. Always seek professional advice from multiple reliable and trusted sources when it comes to choosing the best loan for your situation. No matter what you choose, building a new construction home is the best way to ensure that your investment is perfectly suited for you to enjoy for many years to come.
Melanie Theriault is a writer, counselor, and lifelong learner. She holds a B.A. in Sociology from Southwestern University, where she discovered her passion for fostering human connection through storytelling.