In this how-to, you'll learn
- How construction loans work and what you need to do in order to apply.
- The different types of construction loans on the market and how they differ.
- How to improve your credit score and debt-to-income ratio to get approved for a loan.
- Expert tips on how ot make it work for you and your goals for your home.
Recently, when my husband and I bought a fixer-upper house, we thought we could fix it up little by little. Each month we’d spend a portion of our month’s budget and get a project done. Power-cleaning the driveway, putting in flower displays, caulking the showers, and upgrading the windows were well within our reach, and fairly easy to accomplish. Inevitably, however, we had to consider those big-ticket fixes on our wish list, the ones we’d been putting off. Gutting that desert of a back yard? Putting in a deck and a gazebo? Adding on a much-needed bedroom? These were all items requiring either a construction loan or a miracle to accomplish.
We started looking into the various construction and home improvement loan products on the market and promptly ran off to hide our heads in the sand lot which made up our back yard. Soon, though, we remembered how much nicer grass and a gazebo would be, and trudged back to our research, determined to find the funds we needed to create a paradise. The result is our nice new home, all fixed up, and the wealth of crucial information you’ll find below.
How Do Construction Loans Work?
Technically, a construction loan is a monetary loan that finances all or part of the construction of any real estate building project. They are normally short-term loans, lasting from one year to three years. Typically, they are taken out before the long-term financing is put into place.
Certain prominent financial institutions offer the kind of loan my husband and I needed, a Home Mortgage Loan. This loan is designed to help those who, like my husband and I, wish to renovate an existing home.
Those in the know call construction loans by the quaint name, “story loans.” The lender makes you tell the complete story lurking behind your request, along with your plans for renovation or construction, or no dough. Bankrate says that story loans differ from Fannie Mae and Freddie Mac home loans, in that they need not be standardized.
What Type of Loan? Choosing from Column A or Column B
Everybody’s situation is different, so you’ll want to check with your financial planner to figure out the best option for your individual case. We found out right away that we needed to choose between two types of construction loans: “construction-only” and “construction-to-permanent mortgage.” Here’s the difference:
- “Construction-only” loans simply pay for the construction costs of your building project. Choose this type, and you’ll make payments on the loan’s interest until either the contract is up, or the project is finished. At that time, your principle comes due. Bankrate labels this type of loan the “two-loan approach” because it allows you to choose two separate lenders. Others call it a “new construction loan” or an “end loan.”
- “Construction-to-permanent mortgage” loans usually roll over the payments on the construction costs into a permanent mortgage. Lenders like these better because of their profitability. These are also referred to as “One-step” or “construction/permanent” loans.
How to Qualify: Don't Give Up, Put Up!
We also discovered that it can be difficult to secure both a good lender and a good construction loan. Many lending institutions completely suspended programs for construction loans during the latest economic chaos. They really want to be sure you have what it takes, financially.
Guidelines have also tightened. For example, to qualify, you’ll usually need:
- A credit score of above 680 for a loan below $417K, and above 700 if you’re borrowing more.
- A W2 from your employer or, if you’re self-employed, income verified by two years of tax statements
- No more than a 45% Debt-to-Income rating.
- Reserves required will usually run to six months’ worth of PITI (add your Principle, or the loan amount; the Interest, or the lender’s charge; the real estate Taxes; and homeowner’s Insurance). PiTiCalc offers a free calculator here.
[ Principle + Interest + Property Taxes + Insurance = PITI ]
- You should set aside at least a 30% land equity or down payment to cover the construction loan. Many lenders will want 35% down.
- Once you’ve pre-qualified for the type of construction loan you chose, do some comparison shopping of potential lenders in your area. Be sure to compare their experience and the loan-to-cost rate.
- Fill out and submit the application.
- Sign a construction loan contract with the contractor or builder, and buy construction insurance, including liability, workman’s compensation, and “course of construction” insurance.
Making It Work
The savvy folks at realestate.com and Bankrate offer some tips on issues to beware of:
- Realize that construction and mortgage loans rates fluctuate, sometimes over very short periods. Set up your loan as early as you can. You can easily lose your building deposit if you miss the closing date deadline.
- Find out about “float-downs” and “extended locks” before you sign on the dotted line. This will protect you from the consequences of extreme changes in interest rates.
- Ask your lender about “lien waivers,” and how the builder’s sub-contractors’ payments and waivers are to be handled.
- Due to the comparatively risky nature of construction loans for builders, a few unscrupulous lenders may try to pump up the final bill with add-ons and markups. Of course, Great Day Improvements isn’t part of that shady gang. Just remember that in general, if it’s not in the contract, you’ll pay extra for it.
- Try to include a contingency penalty for late completion, paid by the builder. Everybody knows that construction usually takes longer than you think, but few believe they’re the ones this will happen to.
- Those who neglect to plant their feet on their property during each major construction phase may as well hand the builder a Get Out of Work Free card. Watchful involvement is the only way to get what you’re paying for.
Always remember to act only on quotes you have in writing. Mortgage lending is sometimes an ephemeral thing, with terms that magically transform themselves overnight, so lock it up nice and tight before you get out the champagne and shovel.
Mortgage 101 is a great source of online information about this subject. For smaller construction loans designed to cover repairs and renovations, visit the HUD rehab loan webpages and look into FHA Streamlined 203K’s.
Start Your Journey Here
Schedule your free design consultation now for a free consult with an expert Great Day Improvements representative. We can help you design and there’s no obligation for this free service. We also have many types of financing available to turn your dreams into reality!