Home construction loans help you finance your new home from the ground up. This page describes the typical Terms for Home Construction Loans, and is the second part of our article that will help you understand all about construction loans and how they work.
Terms for New Home Construction Loans
In addition to construction budgets, draw schedules, converting loans and some of the other unique aspects of construction loans we’ve described, continue reading to learn about how construction loans work and the typical loan terms. We’ll now look at the following loan terms and characteristics:
- Down Payment/LTV
- Loan Length
- Amortization & Payments
- Interest Rates
- Underwriting & Processing
The crash of the nation’s housing markets directly affected the financial industry and its willingness to extend real estate credit, especially loans for new development, vacant land purchases and new home construction. All of these loan types are considered “riskier” loans by banks, so they simply were not even offered by banks for several years. Under those economic conditions there were not as many borrowers actively seeking these types of loans at that time anyway.
But with housing markets improving and home inventories low, there now is an increased demand for new homes and, by extension, home construction loans. Some banks are starting to slowly respond to that demand by offering these loan products again. Read tips about finding lenders for construction loans in this related article.
On a scale of availability for the loans we’ve discussed – that is, how easy it is to find and get approved for a type of loan – construction loans fit somewhere between purchase money loans for existing homes (highest level of availability) and vacant land and lot loans (lowest level of availability). Like lot and land loans, construction loans inherently are thought to be riskier for banks than a standard purchase money loan to buy an existing home (learn more about why, in this article).
Lenders prefer that construction loans be used for building owner-occupied single family homes, whether it is a first home or second home for the borrower. Banks do not like to fund construction loans for speculative homes or investment properties, so a borrower should intend to live in the home and not be planning to sell it. Some banks will allow owner-occupied multi-family properties like duplexes. Even if you will occupy the property, you likely will find it harder to get a construction loan if you plan to build your own home as an owner-builder.
If you already own your lot or land it’s best to not let any contractors start work on the property before getting your construction loan. Having a third party do work on the site can raise mechanics’ liens concerns that cause a potential construction lender to disqualify the loan altogether.
The lender will want you to have some of your own money or equity in the transaction. Having “skin in the game” gives a borrower incentive to make payments and helps provide some cushion in value for the lender if the loan defaults. Your Loan-to-Value (LTV) ratio will determine how much money you can borrow for building your house and how much equity you need to add as a down payment. A lower LTV ratio means you will be required to provide a higher down payment of cash or equity.
Calculating the LTV ratio for a construction loan is similar to calculating the ratio for a purchase money loan or a lot loan. For construction loans the LTV ratio typically is determined by dividing the loan amount by the lesser of the purchase price (lot price plus construction costs) and the as-completed appraised value (projected value of the lot and finished house). It helps if your new home will be in an active market that provides strong comparable sales, because a low appraisal value may require you to put a larger amount of cash in the transaction for your down payment.
LTV ratios for construction loans often are in the 80% range, meaning there is an expectation that the borrower will have 20% as a down payment or equity in the transaction. Note that if you already own your lot and have equity in the property, you can apply that value to your down payment for the construction loan and decrease the cash you need to put in at closing.
Traditional construction loans are short-term loans and are intended to be paid off as soon as the house has been completed. Instead of a 15 or 30 year term like most purchase money mortgages, a construction loan term generally is around 12 months. Most lenders will allow you to extend the pay off period if it is necessary because of unavoidable construction delays and other factors.
Even with a Construction-to-Permanent loan, the first-phase construction loan piece is expected to be paid off in about 12 months (but sometimes may be extended). The overall term for the loan, including the time period after it converts to a permanent loan, can be more like a purchase money mortgage and include options like 15 or 30 year periods.
Amortization & Payments
Monthly payments under construction loans are very different when compared to the land loans and purchase money loans we’ve described in this series. During the construction phase a borrower usually only makes interest payments (not principal) under a construction loan. And during this construction period a borrower is charged interest only on the amount of the funds that actually have been disbursed for construction.
Unlike the interest-only construction phase, the permanent loan phase for a Construction-to-Permanent loan typically will be amortized much like a standard purchase money mortgage. This means that after the home’s construction has been completed and the loan has converted to a permanent mortgage, monthly payments of both principal and interest must be paid by the homeowner. The monthly payment amount will be determined by amortizing the total amount of the funds disbursed under the construction loan over the remainder of your selected amortization time period (like 15 or 30 years).
To help borrowers with their cash flow, construction loans may be structured with interest reserves. At closing funds are allocated to an interest reserve account that is used solely for paying interest during the construction phase. Monthly interest payments are pulled from this account so that the borrower does not have to make monthly payments until after construction has been completed. Interest reserves are attractive to borrowers who already will be paying a monthly mortgage or rent payment while waiting for their home to be completed.
Short-term loans typically are charged higher interest rates than long-term loans, and short-term construction loans are no different. Rates will vary, but you can expect to see interest rates fornon-converting, short-term construction loans at least a percentage point (1%) higher than most conforming 30 year purchase money loans.
Many lenders provide better rates if you are using a Construction-to-Permanent loan product, although the rates still may be around a quarter point higher than the market rate for a standard purchase money loan. Sometimes the rate is higher during the interest only construction phase, but banks may allow you to have the same rate structure during the construction period as you would for the permanent loan period. Construction loans often convert into adjustable interest rate mortgages after completion of the home, but some lenders offer long-term fixed rate loans after conversion. Interest rates vary, but for comparison purposes (ask your lender to show you a comparison chart) that show one lender’s rates for their construction loans and other loans products.
Borrowers may wish to consider interest rate protection options. Rate lock programs allow you to lock in the permanent loan rate at the time of your application (before closing and construction even begins). This is helpful if you think rates will be rising.
Some banks charge additional fees for construction loans like inspection fees, draw processing fees and rate lock fees (when applicable).
Scheduled draws, inspections, title updates and other safeguards help construction loans be structured and administered by the bank to balance the amount of funds disbursed with the value of the asset or collateral that secures its loan. These protections help reduce a bank’s risk and limit the amount of funds disbursed to the actual work that has been completed on the home. The loan amount only increases when the value of the collateral increases.
The concept of collateral also is related to the down payment or equity that the borrower has in the transaction and the LTV ratio. Cash, equity and other pledged assets from a borrower are collateral that provide comfort to lenders when there is a default under a loan. As noted above, if a borrower already owns its lot then equity in that property can be used as part of the down payment for its construction loan.
Underwriting & Processing
The underwriting process – along with paperwork and time required by the borrower – is very rigorous for approving construction loans. Not only will a borrower need to pass a review of its financial capabilities, but the borrower also must have its homesite, house designs, specifications, budget, construction contract and home builder, among other things, approved by the bank prior to closing.
A lender will want evidence that you either own your lot or have it safely under contract. Lenders also will pay attention to the suitability of your proposed home, so they may scrutinize your lot to make sure the home will not be too expensive for the area. Banks will confirm that you are using a well-respected and reputable home builder and may require you to use a licensed home builder. The builder should have positive references from former customers and should be able to show the bank that it has appropriate insurance coverage. Most banks do not want the home to be built by an inexperienced owner-builder.
And the paperwork does not end after the loan closes. During the construction phase after closing, while you’re already busy working with your builder, checking your budget and seeing your dream home take form, the process of administering your construction loan will continue to be quite tedious for both you and your builder. Loan processing activities include processing and tracking draw requests, progress inspections, mechanics’ lien waivers and other loan-related items.
We hope this series of articles has helped you learn and understand more about construction loans, lot loans and land loans.