Home Construction Loans: What You Need To Know

By Mark Di Vincenzo. May 7th 2016

In the wake of the housing crash that triggered millions of foreclosures nationwide, most cities still have a large supply of houses for sale and most of those houses are a bargain.

And yet many thousands of home shoppers aren’t interested. They want to design and build their own houses so they buy lots and they hire architects to design the houses of their dreams.

The vast majority of these people don’t have enough money in their bank or investment accounts to pay their builders, so they need to borrow the money which comes from construction loans. The amount of a construction loan depends on the price in the contract that the homeowner signs with the builder. If the contract is for, say, $300,000, very often the construction loan will exceed that amount by $5,000 to $25,000 because often homeowners order changes to the design that inflate the initial price.

Here are some other things you need to know about construction loans.

They Are Short-Term Loans

The length of a construction loan, known as the term, is often 12 months, assuming the builder can build the house in less than a year. If the house is very large or if it has complex features that make it take longer to build, the length of the loan can be longer than that. Assuming the term is 12 months, the homeowner has that much time to find a permanent mortgage which will be used to repay the bank that offered the construction loan. Failure to do that will result in large fees and possibly foreclosure by the bank.

Construction Loans Are More Expensive Than Traditional Mortgage Loans

They come with higher interest rates -- typically at least one percentage point higher than the borrower could get from a permanent mortgage. The interest rate may be fixed or it may be variable, which means the rate can go up and down during the length of the loan. (To learn more about variable rate mortgages, see The Pros And Cons Of Adjustable Rate Mortgage Loans.)

They Usually Are Interest-Only Loans

During the length of the loan, the borrower usually has the option of making principal payments, but many just pay interest. The upside to that is the borrower is paying a smaller monthly payment than if he was also paying principal and mortgage insurance. The downside is that the homeowner is accumulating no equity if he is only making interest payments. (However, a homeowner who only makes interest payments can accumulate equity if the land he bought appreciates during construction and if the builder does the work for a relatively low price. Under that scenario, the house may appraise for more than the combined total of what the homeowner paid for the land and what he paid the builder.) (For more information on interest-only mortgages, see Understanding The Different Types Of Mortgage Loans.)

The Underwriting Process Is Different

When a borrower wants to refinance a mortgage or apply for a new one, the lender’s underwriters focus on the borrower’s assets, wages and debts. If a borrower applies for a construction loan, the lender’s underwriters not only examine the borrower’s finances, but they also investigate the builder’s finances and his ability to build the house.

With A Construction Loan, The Lender Requires The Borrower To Post Collateral

The collateral can be the lot where the house is being built, assuming the homeowner owns it free and clear, or it can be other assets the homeowner owns.

Insurance Isn’t Optional

Not only must title insurance be secured, but the homeowner must buy flood insurance if the house is in a flood zone. And the builder must obtain at least a year’s worth of builders risk insurance which protects the house if there is a fire or other event that damages or destroys the house before the homeowner can move in. Builders charge homeowners for this insurance and if the house is built in less than a year, builders sometimes keep any unused and refunded portion which should go to the homeowners. For this reason, homeowners should pay out of pocket for this insurance so they will receive any refunded portion. (To learn more about flood insurance, see Why You Should Purchase Home Flood Insurance Coverage.)

There Must Be An Appraisal

The bank requires an appraisal before construction begins because it does not want the construction loan to exceed 75 percent of the value of the house. With no house to appraise, the appraiser must base the appraisal on what other, similar houses in the same neighborhood have sold for in recent months.

Inspections Occur Throughout The Construction Process

The lender’s inspector checks the builder’s work periodically and issues progress reports. If, after the first inspection, the inspector says the builder has completed 20 percent of the work, the lender, with the homeowner’s approval, will give the builder 20 percent of the amount of the contract price. These inspections continue until the builder finishes his work and has received the money he has earned.

If, for example, the builder finishes in nine months and the term of the loan is 12 months, the homeowner still has three months to obtain a permanent mortgage. The construction loan exists until the homeowner obtains that mortgage and can repay the construction loan.

If you are considering getting a construction loan for your dream house, make sure that you get up to speed on how construction loans work. This will help you to avoid heartache down the road.

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