What is a construction loan?
A home construction loan is designed to facilitate the construction process of building a new home. Designed to be short-term and high-interest, construction loans typically have one-year terms and finance the costs that go into construction, such as supplies, labor or permits.
While the home is being built, the lender pays the contractor in installments until the building process is complete. Once the project is finished, the borrower has a few options: Refinance the loan to be paid off through a traditional mortgage, obtain a new loan with more favorable terms to pay off the construction loan or pay the loan in full to the lender.
With a construction loan, you will typically pay a percentage of the appraised value of the home in a down payment. Then you will only pay interest on the money that was borrowed throughout the construction process.
As someone with personal experience obtaining a construction loan, I learned how important it is to talk to different lenders to get a feel for what’s in store. For example, if you go through a bank, it may offer lower rates if you bank with it. Some simply provide rates with no other requirements. Others offer the construction loan and then can convert it to a permanent loan.
As with any big financial decision, it’s a good idea to familiarize yourself with the intricacies of the process and what to expect. After all, construction loans are nontraditional in terms of how they work, so you want to feel comfortable and confident when it’s time to apply.
Benefits of a construction loan
Construction loans have lots of flexibility in their terms and guidelines compared with traditional loans. You can even customize those terms for the specific needs of your project.
Another benefit of building your home with the help of a construction loan is that you are using an established lender for the financing, rather than a personal loan or home-equity line of credit.
Additionally, the payments are interest-only during the building process. Unlike a traditional mortgage loan, construction loans also do not include any principal payments, and you will only have to pay closing costs once.
The added scrutiny imposed on such projects can also ultimately work in your favor. Builders are paid by the lender only when they meet certain milestones in the construction, which helps keep the process moving forward and presumably forces the project to stay on budget.
Risks to keep in mind
While you benefit from a home construction loan’s flexibility, it also comes with higher standards.
A construction loan is not a normal mortgage, so naturally, there is more potential for things to go wrong. Because you are taking on more risk with a construction loan, it also tends to be more difficult to qualify for. Additionally, interest rates tend to be higher and more variable.
Be prepared for your lender to be strict in the underwriting process. To ensure you are qualified for the loan, lenders will dig deep into your financial situation. You should aim for a credit score of 680 or higher, and you should be prepared to deliver on a down payment of at least 20 percent.
The shorter time-frame of the loan can also impose risk. As one can imagine, having only one year to build a home is a large feat, especially if you run into any delays.
How has the coronavirus pandemic affected construction loans?
When it comes to construction, it seems as though everything is behind schedule because of the pandemic.
Projects are taking much longer than usual as a result of record high demands and scarce supply. Any shortages or delays in the supply chain can quickly put you days, weeks or even months behind schedule — which will ultimately cost you money in the long run.
Before you break ground on your new home, it’s a good idea to speak to a financial adviser. They can help you understand the potential impacts a construction loan could have on your long-term finances, both now and in retirement.
David Mount is a director with the Wise Investor Group at Robert W. Baird & Co. in Reston, Va. Baird does not provide tax, legal or real estate advice, and does not provide or service mortgages.
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