Construction Loans: Everything You Need To Know
Carey Chesney6-minute read
August 20, 2020
Finding the perfect house can be a fun yet challenging endeavor. With so many styles to choose from – colonial, ranch, midcentury modern, townhouse and tudor, just to name a few – sometimes people don’t know where to even start.
And if you've decided on your favorite style, a slew of other factors come into play. What are your must-haves? An attached garage? First-floor laundry? A minimum of three bedrooms and two bathrooms? Does it need to be near a school, close to work or on a lake? What kind of climate do you prefer? It’s a lot!
With all these factors floating around in your head and a limited number of homes on the market, finding your dream home in your dream location within your budget can seem impossible. Often, home searchers find that some houses meet most of their needs, some meet a few and some meet none, but rarely does one meet them all. This creates the need to compromise and move some of your “must-haves” to “nice-to-haves,” but not deal-breakers.
Don't feel like giving an inch on your wants and needs? Fear not, because if your perfect home isn't available (or doesn't even exist), you can build a new one! This allows you to create the picture-perfect home without worrying about the color taste of the previous owners, a kitchen layout that makes no sense to you and all the other limiting factors of buying a home that’s already been lived in. However, to finance home construction, a little more education on the subject of construction loans is important. So here we go.
What Is A Construction Loan?
A construction loan is a short-term loan that covers only the costs of custom home building. Once the home is built, the prospective occupant must apply for a mortgage to pay for the completed home.
However, there are several other loans available when it comes to home building, from ground-up building to completely gutting a current home so you can renovate. So, whether you have a plot of land and need to start from scratch, have a teardown situation where the current home has no redeeming value in your eyes or want to keep the bones of the structure but change pretty much everything on the inside, there’s likely a loan out there that’s right for you.
This type of loan is short-term and is usually issued for a year. It’s meant to cover only the actual construction period. Like many lenders, Rocket Mortgage® doesn’t offer this type of loan. Why? With so many variables like the builder’s cooperation, getting approvals from local municipalities and more, these are considered higher-risk loans. This means they’re harder to qualify for and the interest rates will likely be higher than a traditional loan. In addition, if you decide to go this route, you’ll have to pay a second set of loan fees when you apply for a traditional mortgage.
This is a type of loan that prospective custom home builders can apply for. Much like construction-only loans, construction-to-permanent loans are one-time loans that fund construction, but then convert into a permanent mortgage. During the construction phase, borrowers make interest-only payments. It’s important to note that these types of loans can be much more expensive than traditional mortgages, so if you decide to go this direction, be sure to shop around, compare rates and find the best deal before you pull the trigger.
Renovation loans, also known as 203(k) loans, can be used for home renovation and are insured by the Federal Housing Administration (FHA). Rocket Mortgage® doesn’t offer this type of loan. This allows borrowers to both purchase and renovate their new home while still making one monthly payment to cover both costs. Conventional loan borrowers may qualify for these loans through Fannie Mae (HomeStyle Renovation) and Freddie Mac (CHOICE Renovation).
Rocket Mortgage® does offer a cash-out refinance, which can be a different path to getting home renovations done. With a cash-out refinance, you take a portion of your equity and add what you've taken out onto your new mortgage principal. Other options include a home equity loan or a home equity line of credit (HELOC). No matter what you want to change about your home, there are plenty of options to get the financing you need to start swinging that sledgehammer.
Usually when you build a home, there’s a general contractor who essentially acts as the quarterback of the whole operation. They make sure the framing people, the tile people, the wood floor people, the painters and so on all work in coordination to get your home completed (ideally on time and on budget).
However, some prospective home builders wish to act as their own general contractor, and some banks offer owner-builder loans just for this purpose. These types of loans generally require the borrower to demonstrate through experience, education and licensing that they have the needed expertise to oversee the home’s construction. Sorry, no newbies allowed here.
An end loan is a traditional mortgage that a home buyer or home builder (if you’re building your own home) can apply for after the new home is constructed. Unlike some of the other construction loans previously discussed, these are offered by Rocket Mortgage®.
You can get an end loan if construction is complete on the home. One good aspect of an end loan is that the mortgage application for a newly constructed home is the same as it is for any other home. Less complicated is always appreciated when it comes to financing applications.
Construction Loan FAQs
Hopefully you have a nice base of knowledge about construction loans after reading this far, but there are likely a few queries still on your mind. Let’s take a look at some of the most frequently asked questions when it comes to construction loans.
Are There Higher Qualification Requirements For Construction Loans?
Yes, construction loans often come with higher qualifying standards in terms of credit requirements and down payment amounts. Usually a minimum 20% down payment is required, and a 25% down payment requirement is not uncommon. In addition, most construction loans require a minimum credit rating of 620.
Why, you ask? Construction loans come with a lot more risk to the lender, being shorter-term and coming with a whole plethora of additional variables when compared to a traditional mortgage. When lenders see more risk, they ask for more qualifications – and more money. It’s as simple as that.
Can I Use Any Excess Funds For Home Furnishings?
Wouldn't that be sweet? Get that fancy cushy couch and massive flat screen TV and the living room is ready to rock. Sorry, but borrowers never actually touch the funds made available through construction loans because they’re paid directly to the builder.
Unfortunately, if there’s money left over after all the construction costs are taken care of, you don't get to touch that either. The contractor only receives payment for the work performed, and the borrower only pays interest on what’s paid out. You do save money if construction costs come in below the original amount of the loan, but you’ll have to find some other source of funds for that flat screen.
Do Construction Loans Cover The Design Phase Of Home Construction?
Sorry, another no here. Prospective custom home builders have to self-finance the design phase of the home building contract. In addition, before you can take out a construction loan, you’ll need to produce a builder’s contract, construction timetable, designs and a realistic budget. All this needs to be done even before beginning the loan application process. Have you been putting off that touch base call to your architect cousin? Time to give them a ring.
Summary: Construction Loans Can Make Your Dream A Reality
If it doesn't look like your ideal home is available while you peruse the listings in your preferred market, the dream doesn't have to end. Envisioning the perfect mix of location, style and usability in a home is one of the most fun parts of the home buying process, and it doesn't have to be just a vision. You can design, build and furnish the exact home you want with a variety of financial paths to help get you there.
Whether it’s a construction loan, a renovation loan, a HELOC or any other number of options, finding the right way to borrow money for your next home doesn't have to be too hard. Research all the options, figure out the best type of loan for your specific needs and shop around for the best price.
Still not sure where to go next? A great way to continue learning more about how to finance your real estate dreams is a visit to the Rocket Mortgage® Learning Center.
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