Is a Construction Loan Right for You?

construction loan
If this spring is the time for you to finally make your dream home a reality, then you should know some things about construction loans and how they differ from traditional mortgages. Because most mortgages have the existing house as collateral, construction loans are seen as a greater risk and therefore come with unique guidelines and systems for monitoring the process. But there are some real advantages as well. Building ensures you will have everything you want in your home—exactly where and how you want it. You aren’t likely to find that in a pre-existing house. So, if you are ready to build, it may be worth your time to learn about construction loans and how they might help your dream home become a reality.

Construction Loan Basics

What is a construction loan?

Effectively, a construction loan is a line of credit used to pay for the work on your new home as it is being built. Because the work follows a pre-approved, phased schedule, you only have to pay interest on what has been spent so far, rather than on the entire loan. Construction loans can be separate from the mortgage, or rolled together in what is known as a “construction to permanent” loan (which allows you to only pay one set of closing costs). The interest rates are tied to the prime rate and are higher than those of traditional mortgage loans.

What are the differences in the two types of construction loans?

Construction to permanent loans convert to a permanent mortgage when the house is completed. Interest rates are locked in at closing. Because there is only one closing, they do not require as much cash reserves. By contrast, a construction-only loan must be paid off as soon as the house is complete, but allows you to shop for a permanent lender during the construction process. While you will have to pay multiple closing costs, if you have the cash reserves, this option provides more flexibility.

What will a construction loan cover?

Every project and every loan can be different, but generally, the following things can be negotiated into a construction loan:

  • The cost of the lot
  • Money for permits and fees
  • Construction materials and labor costs
  • Closing costs
  • Contingency reserves—in case the project goes overestimates or if you don’t want to make the required interest payments while the house is being built.

The Construction Loan Approval Process and Costs

What is involved in the approval process?

Before your construction loan can be approved, you’ll need to provide the lender with your personal financial information, including past tax returns, pay stubs, and an accurate budget. You’ll also need detailed plans for the house, which will likely include blueprints and decisions about materials, as well as a construction timetable. Be sure to leave some cushion in the build schedule, as weather and labor availabilities can (and often do) cause delays along the way.

What will my up-front costs be?

You can expect to pay at least 20% as a down payment. If you already own the land you’ll be building on, then that can serve to provide equity. Don’t be surprised if construction costs creep higher than estimated during the building process as you make last-minute trim and detail decisions. Be prepared with enough cash savings on hand to cover this.

Other Considerations When Deciding on a Construction Loan

How do I find a builder I can trust?

Since you are getting a loan on something that doesn’t yet exist, it is especially important that you work with a reputable builder you can trust. You will need to do your homework. Make sure to check references and choose someone local. You want to choose a licensed general contractor with an established reputation for building quality houses. Having ties to the community means they have to care about their reputation. Read online reviews, consult their vendors, and find examples of their work that you can check out yourself. You want to find a builder with a reputation for completing work on time and within budget.

Can I get a construction loan for repairs or renovations?

Yes. If you are one of those visionaries who can see your perfect house in the run-down remains of an old home, a construction loan can set you up to roll the costs of renovations into your mortgage. The amount the financial institution will loan you will depend on an appraisal of the future value of the home after the renovations are complete. Utilizing a construction loan for a big renovation project will allow you a longer repayment period, and likely lower interest rates than a personal loan.

Are there any downsides to be aware of?

While construction loans can make it possible to build just the home you want, they do involve unique risks. If your home cannot be completed on time or meet budget, you may have to pay additional costs. You could end up with two mortgages for longer than you planned, or having to pay rental costs. Another potential risk is that your completed home will not be worth its building costs. If the market dips during the construction process, or if the builder does a poor job, you might be scrambling for cash to complete the transition from the construction loan to the mortgage.

Under the right circumstances, construction loans can be a great way to get into your dream house. However, approval is a complicated process that requires expert advice along the way to make sure you avoid pitfalls and end up loving your new home. Call today to speak with an SC Telco mortgage expert about how a construction loan might help you.

SC Telco

Federal Credit Union

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