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A Beginner's Guide to Construction Loans

April 1, 2021 by Space Coast Credit Union



Home construction loans can make the dream of building your own home or renovation into a reality. Many homeowners are familiar with needing a mortgage to buy an existing home but may not be as accustomed to how construction loans work on new builds or remodels.

We've created this construction loan guide to help you understand everything you need to know about how construction loans work and how these unique instruments can benefit you during construction.

 

Home Construction Loans 101

Home construction loans can be used for a new home build or for a renovation. A construction loan is like a traditional mortgage in that both have a process involving approvals, appraisals, and loan disbursements, but the way that a construction loan operates is quite different.

Construction loans are generally created with a shorter term than a traditional 30-year fixed-rate mortgage. In fact, some construction loans are termed for one year or only as long as it takes to complete the build. A construction loan also typically has a higher interest rate since the underlying asset, i.e., the house, is not yet complete, which increases the risk for a lender.

When a home build or renovation is complete, borrowers will often look to refinance a construction loan into a longer-term mortgage. How construction loans operate depends on the terms of the loan. While some construction loans require interest payments during construction, others won't—it all depends on how the loan is set up by the lender. Always make sure you understand all of the terms of a construction loan before moving forward.

 

How It's Made: Construction Loan Edition

When a construction loan is finalized, lenders will often send the funds to the general contractor in charge of the new home build or renovation. These disbursements may also come in stages throughout the project, depending on different milestones set forth in the loan agreement. Since these loan types are slightly more risky for the lender, many home construction loans will require a larger down payment, in addition to the higher interest rates mentioned earlier.

When purchasing a new home, buyers will often have the choice of how much they want to pay as a down payment. A 20% down payment is common and, in many cases, helps to avoid paying ongoing mortgage insurance premiums. Certain borrowers, such as new homeowners, may be required to put down far less—even as low as 3.5% with FHA's new homebuyer program. However, construction loans work a little differently, and many require a 20% or greater down payment in order to secure the loan. The interest rates tend to be a variable rate set to a predetermined benchmark or index.

A typical home construction project takes less than a year to complete, which is a common term for a construction loan. During this phase, generally, only interest payments are required. If you're using a construction-to-permanent loan (outlined in more detail below), once construction is complete and it passes inspection, the loan automatically converts to a traditional mortgage.

 

Different Types of Home Construction Loans

Just like traditional mortgages, there are many different types of home loans, each with its own unique terms. We'll dive into each type of construction loan next and explore one type that has many advantages and that SCCU often recommends to our members.

Types of home construction loans include:

● Construction-to-Permanent Loan: One of the most convenient construction loan types is a construction-to-permanent. A construction-to-permanent loan only requires the borrower to go through a single application and closing process. At the end of construction, the loan is automatically converted into a permanent loan that's best suited for the borrower's situation.

Throughout the build, funds are drawn directly from the loan in order to pay the contractor doing the work. Each draw will typically coincide with the completion of a major milestone, such as pouring the foundation or finishing framing. As well, each phase has an inspection to ensure everything is on-track. Construction-to-permanent loans are great for those who are looking to save on closing costs and who don't want the hassle of trying to get new financing after the build is complete. All of SCCU’s construction loans are construction-to-permanent, saving you money and time when it’s time to move in.

● Construction-Only Loan: A construction-only loan is typically a shorter-term loan and comes with a variable interest rate. Once the construction phase is complete, this loan is paid in full and/or refinanced into a new permanent mortgage. There are separate applications and closings for each loan, which can make this strategy more expensive and time-consuming.

Construction-only loans do have advantages for homeowners who will have enough cash in hand to pay off the construction loan once construction is complete. This may happen when someone plans to pay off the construction phase with proceeds from the sale of a previous property.

● Renovation Construction Loan: In a renovation construction loan, the costs of the renovations are rolled into a mortgage instead of having to be financed after the closing. Renovation construction loans are based on the estimated appraised value of the home after the renovations are complete, so they may entail higher interest rates based on risk.

Renovation construction loans are useful for homebuyers who have their eyes set on their dream fixer-upper but don't have all the funds needed to complete renovations. A common element of home renovation loans is the need for specialized mortgage insurance.

● Owner-Builder Construction Loan: When a homeowner is both the borrower and the contractor, a special mortgage known as an owner-builder construction loan is needed. In an owner-builder construction loan, the construction draws needed are paid directly to the owner or their representative, rather than a pre-approved contractor.

An owner-builder construction loan is less common as the owner will need significant and demonstrable experience and/or licensure as a general contractor in order for the loan to be approved .

When you begin the process of applying for a construction loan from SCCU, our loan officers take the time to understand your situation and your dreams for the home. While there are many different loan programs even within the categories presented above, our loan officers are skilled at helping borrowers discover the best loan to match their unique situation.

 

How to Get the Best Construction Loan Rates

Similar to the rates of traditional mortgages and other loans, construction loans vary considerably based on factors such as the credit history of the borrower, how large the loan is, and the length of the loan payment term. Construction home loans can be based on a variable rate that can fluctuate over the term of the loan depending on the index to which it's fixed. This option can be popular for those who believe the value of the home will likely increase and allows them to refinance later at a better fixed rate.

While there are many variables that can affect the interest rate of your home construction loan, there are a few steps you can take to help boost your creditworthiness and, in turn, secure a better rate.

Construction Loans

Effective Date: October 14, 2021
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Term Rate "As Low As" APR* "As Low As" Example Loan Amount Example Monthly Payment
10 Years 2.875% 3.085% $200,000 $1,919.70
15 Years 3.000% 3.145% $200,000 $1,381.16
15 Years Jumbo 3.125% 3.178% $548,251 $3,819.17
20 Years 3.500% 3.614% $200,000 $1,159.92
30 Years 3.500% 3.581% $200,000 $898.09
30 Years Jumbo 3.625% 3.655% $548,251 $2,500.31
SCCU construction loans are construction-to-permanent loans, with a 12-month construction period. Once construction is complete, final inspection has cleared, and certificate of occupancy (CO) has been received, the loan automatically converts from construction to the permanent loan that the member selected prior to beginning construction. If construction extends past the 12-month initial period, the rate lock will expire and the rate will be reset at the higher of current rate or the initial lock-in rate. SCCU may agree to make an exception and extend the construction phase of the loan. Any such extension may result in changes in to the rate, payment amounts, and closing costs.

During construction phase, SCCU makes payments to the builder at certain key points during construction. During this period, member loan payments are interest-only, based on the total amount of money that has been advanced by SCCU to the builder. The payments to the builder are contingent upon passing required inspections. During this phase, the interest-only payments will vary monthly, depending upon the total amount paid to the builder at the time of each payment calculation. Payment examples above are given for the permanent phase of the loan only, and do not include the interest-only construction phase payments. At initial closing, SCCU collects $1,400 to cover the costs of inspections and builder disbursement. Any funds remaining after CO is issued will be refunded to the member. If actual disbursement charges are greater than $1,400, the member will not be charged above the initial $1,400.

Jumbo Loans available on loans greater than $548,250.

Taxes and insurance not included, your actual payment obligation will be higher.
1. Pay down debt: A lower debt-to-income ratio is ideal for getting a great rate on a construction loan. If you are planning on acquiring this loan in the future, take steps now to reduce your overall debt load to produce a better ratio for loan officers to consider. Calculating your debt-to-income ratio is fairly easy. Just divide the total debt payments you make each month by how much money you bring in during the same period. Multiply this fraction by 100 to get a percentage. Financial managers advise keeping a debt-to-income ratio at, or below, 35%. For a more in-depth look at ways you can strategically pay down debt, check out the SCCU Guide to Financial Freedom.

2. Check your credit score: Knowing your credit score ahead of time can help save you headaches after applying. If you notice errors on your credit report, you can file a dispute with the credit bureau to have these removed. Since derogatory marks negatively impact your credit score, eliminating any mistakes prior to applying for a loan is critical.

3. Increase credit limits: While this may seem counterintuitive, requesting a raise to your current credit limits can actually increase your credit score. When you've had a good history of on-time payments, your credit issuer may be willing to increase the amount of credit they'll extend. Raising your credit limit can also lower your credit card utilization ratio and create a two-pronged approach to increasing your credit score. Combine these benefits with a low-interest credit card like those offered by your credit union, and you can create a great opportunity to build a solid credit history.

A low-interest environment is ideal for borrowers and rates today are competitive. By using a credit union, you can generally obtain lower-interest construction home loans.

Checking out SCCU's construction loan page gets you a quick overview of the current rates offered. For construction loan details and a personalized rate quote, contact us or request a loan consultation with an SCCU Express Mortgage Originator.

 

What Are the Requirements for Construction Loans?

Now that we know how home construction loans work, let's take a step back to understand the requirements for approval. The process for construction loans is generally more involved than a traditional mortgage since the loan has an underlying asset that either doesn't yet exist or is in the process of being renovated.

With construction loans, the lender will still have many of the same standards as a traditional mortgage application, such as requiring a detailed work history, bank statements, income verification, and other necessary information and documentation. In addition, the lender also assumes the role of a quasi-construction manager, requiring the review and approval of the builder or contractor and for the building plans, a project budget, and a timeline for completion. 

Getting approved for a construction loan may depend on a number of factors, such as:

● Having a very good to excellent credit score. Your credit score is a general representation of your credit risk, which is how likely it is that you'll be able to pay your debts on time each month. According to consumer credit reporting agency Equifax, a "Very Good" credit rating is between 740 to 799, with "Excellent" being 800 to 850. A "Good" rating (670 to 739) may still get approved, depending on other factors.

● Having enough income to pay the debt. When it comes down to applying, you'll need to be able to demonstrate you have enough income to keep up with payments. A sound financial management theory known as the 28/36 rule states that you should spend 28% or less of your gross monthly income on housing and 36% or less on the total debt payments made each month.

● Maintaining a low debt-to-income ratio. As discussed above, construction loan lenders are looking for a healthy debt-to-income ratio. A low ratio translates into a borrower generally having more liquid funds available to make loan payments each month.

● The ability to put at least 20% down. Remember that construction loans will typically require a down payment of at least 20%, with many programs requiring more than this. There are variations to this rule, but putting down less than 20% may result in higher interest rates and may also subject the loan to mortgage insurance premiums.

● Having a good home construction project schedule and budget. Since construction loans are riskier for lenders than traditional mortgages, they need to see the plans in place are provided by professionals with a solid track record for success. Make sure you select a qualified contractor that is both licensed and experienced, as well as able to provide all the necessary documentation to keep the project on-time and on-budget. Among other things, you'll most likely need copies of their current licensure, work history, and insurance certificates (often naming the lender as an additional insured). In many cases, lenders maintain lists of “approved builders.” You may want to ensure that your builder is on your chosen lender’s list, or can meet the qualifications to be added.

● Organizing your paperwork. Your lender will want to see as much detail as possible when reviewing your loan application. After you've found a licensed, insured, and experienced general contractor, providing other pertinent documents  will help your lender evaluate your application more quickly. Have documents such as these on hand and ready: a land deed, blueprints, budget, draw schedule, contracts, and more. As you start the process, make sure to maintain good records to present all of the information to your lender in an easily transferable manner.

Knowing your lender's requirements before you start is a good way to ensure you're working towards checking off all the boxes needed to approve the loan. To facilitate this, you can schedule a loan consultation to get a better understanding of everything required.

 

Getting a Construction Loan as a First-Time Homebuyer

Reading this far may have you worried if you're a first-time homebuyer. Will you qualify for a construction loan if this is your first home? The good news is that even if this is your first home, you can still qualify for a home construction loan.

Just like with any mortgage application, first-time homebuyers can qualify for a loan based on factors such as creditworthiness, debt-to-income ratio, a history of on-time bill payments, etc. Making sure to present the best picture possible is key.

If your credit score is somewhat low, take steps before applying to bolster your score. If you have a lot of debt, work to pay this down. Also, it's a good idea to go ahead and start a savings fund for the down payment and other costs. Proactively planning for the requirements of a construction loan will leave you far better prepared when you're ready to apply.

 

Choosing a Home Construction Loan Lender

Remember that not all construction loan lenders are created equal. The loan officer at the lender has a lot to do with the successful (and headache-free) completion of your construction loan. Making sure to do your part also plays an important role in successfully preparing for a home construction loan application, but doing some due diligence on your lender is recommended as well.

Make sure to compare various lenders' home construction loan rates and general terms. Also, pay close attention to the down payment requirements and closing costs. In general, credit unions are able to offer lower rates and lower fees than banks because of how the institutions are structured. You'll also want to make sure that the lender(s) you're looking at offer the type of construction loan needed in your unique situation.

Just within the four types of construction loans we presented above, there are many different programs, each with its own requirements. Experience matters in construction loans, and your lender will play a large role in how successful the project is.

 

Home Construction Loans vs. Traditional Mortgages

When you purchase an existing home, you'll go through a conventional mortgage process. Most conventional mortgages are termed at 30 years, with 15-year terms that may offer lower interest rates. However, as we've seen with a new construction or major home renovation, a traditional mortgage is not best suited for this application, and a home construction loan will most likely have all of the features you need.

A few of the major differences between traditional mortgages and construction loans include:

● Traditional mortgages can require as little as 3.5% down. Construction loans generally start at 20% down and go up from there.

● Because of the risk involved, a construction loan's interest rate tends to be higher than a conventional mortgage. Construction loans also usually have more requirements that need to be met in order to qualify.

● Construction loans need a qualified contractor to submit budgets, timelines, contracts, and more in order to be considered by a loan officer. Adding a third-party (outside of yourself and your lender) simply adds an additional layer of risk. You'll need to make sure you've vetted your contractor and that they are familiar with the process and have a track record of successfully delivering on home construction projects and lender requirements.

● The construction phase of these loans typically have much shorter terms, depending on how long the build is scheduled to last. The most common term for a construction phase is one year or less. Comparatively, the most common conventional mortgage has a 30-year term.

● Construction loans are often interest-only based on the draw schedule. The end of the construction phase may trigger the need to pay the balance in full. A construction-to-permanent loan allows borrowers to convert their construction loan into a standard mortgage at the end of the building process.

Construction home loans are incredibly useful for many different scenarios when building a new home or renovating an existing property. Knowing the pros and cons of traditional mortgages versus construction loans, and when each is appropriate, can help you decide which avenue to pursue in your new home search.

 

Additional Loan Types for Home Remodels & Repairs

While home construction loans are great for building new homes or major remodeling projects, they aren't always the best loan type based on your particular situation. If you're looking to finance a smaller home repair or renovation, you may consider a home equity loan (fixed second mortgage, home equity line of credit, a personal loan, or even a low-interest credit card.

These options are generally considered shorter-term solutions and are useful when a quick repair/renovation is needed. Our onsite loan underwriters make it easy to get a decision quickly no matter what type of financing is needed. 

 

Applying for a Home Construction Loan

Getting a home construction loan can be exciting, but feel daunting at the same time. At SCCU, we're here to make the process of building or renovating your dream home as easy as possible.

If you need help with understanding where you are in the process, applying for a construction loan, or any other aspects of our program, check out our Construction Loan page for additional resources.

 
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