By Kerry Gaby, Bell Bank Mortgage
For many, the idea of a custom-built home tailored to their exact specifications is the ultimate dream. But unlike purchasing an existing property, financing new construction requires a specialized approach: the construction loan. These short-term, specialized loans are designed to cover the costs of building a home from the ground up, or even undertaking significant renovations. Understanding how they work is crucial for anyone embarking on this exciting journey.
What is a Construction Loan?
A construction loan is a temporary financing solution that provides funds to cover the various expenses incurred during the home-building process. Unlike a traditional mortgage, which is secured by an existing home, a construction loan is based on the project value of the home once it’s completed.
The key differentiator is how the funds are disbursed. Instead of a single lump sum, construction loan funds are released in stages, known as “draws”. These draws are tied to specific construction milestones. Usually these draws begin with the completion of the foundation, the framing, the roof installation, etc.
This phased disbursement allows lenders to mitigate risk by ensuring the progress aligns with the allocated funds and the project remains on track. During the construction phase the borrowers pay interest only on the amount that has been drawn or disbursed.
Types of Construction Loans
There are several types of construction loans, each with its own advantages:
*Construction-to-Permanent Loans: Also knows as “single-close” loans, these are the most common and often the most convenient. They start as a short-term construction loan and automatically convert into a traditional long-term mortgage once the home is completed. This eliminates the need for a second closing, saving time and additional costs.
*Stand-Alone Construction Loans: Also referred to as “two-time-close” loans, these involve two separate loans. First, a short-term construction loan finances the building phase. Once the construction is complete, the borrower must then apply for a separate, traditional mortgage to pay off the construction loan. While this requires two closings, it can offer more flexibility.
* Renovation Loans: These are specifically designed for major renovations or additions to an existing home, combining the cost of the home and the renovations into a single loan.
How Do Construction Loans Work? The Process Explained
The construction loan process is typically more involved that obtaining a traditional mortgage due to the inherent risks of an unfinished project. Here’s a breakdown of the general steps:
- Chose Your Builder: Before even approaching a lender, it’s crucial to select a reputable and experienced builder. Your Realtor will have recommendations for a builder and lender. Lenders will scrutinize your builder’s credentials, financial stability and track record.
- Develop Detailed Plans and Budget: You will need comprehensive architectural blueprints, a detailed construction timeline, and a line-item budget outlining all the expected costs. This plan is vital for the lender to assess the project’s feasibility and value.
- Prequalification and Lender Selection: Shop around for lenders specializing in construction loans. During prequalification they will assess your financial health, including your credit score, income assets and debt-to-income ratio.
- Application and Underwriting: Submit your formal application along with all the required documentation. This includes income and asset documentation along with the detailed project plans. The lender will obtain a thorough appraisal based on the projected value of the completed home.
- Loan Approval and Closing: Once approved, you will go through the loan closing, where you will sign the necessary documents. At this point you will bring your down payment and closing costs.
- Disbursement of Funds: (Draws as construction progresses, your builder will request draws from the lender at pre-determined milestones. The lender will send an inspector to verify the work completed before releasing funds for each draw. During this phase, you will make interest-only payments on the funds that have been disbursed.
- Project Completion and Conversion: Once construction is finished and the certificate of occupancy is issued, the construction loan will convert into your permanent mortgage, and your regular principal and interest payments will begin. (For stand-alone loans, you will need to secure a separate mortgage to pay off the construction loan.)
A construction loan is a powerful tool for turning your custom home vision into reality. While the process is a little more complex than securing a traditional mortgage, understanding the different types of loans, the steps involved, and the qualification requirements will equip you to navigate this exciting financial journey with confidence. By partnering with a reputable Realtor, builder and knowledgeable lender, you can lay a solid foundation for your dream home.
Kerry Gaby
Sr. Mortgage Loan Officer, NMLS 641778
113 South Monroe Street, Tallahassee, FL 32301
Cell: 850.567.4144
Fax: 855-475-4950
kgaby@bell.bank
My Website | bellbankmortgage.com
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