A home construction loan is a completely different type of loan than any other home loan. Lenders are taking the risk of providing you with funds for a home that is not built yet, which means that there is very little collateral involved in the process. The case is even riskier if you do not own the land which you are building the home on; if the loan will be to purchase the land as well, you will need to have excellent credit and income in order to qualify for the loan.
Credit Requirements for a Construction Loan
Just as is the case with any loan, every lender has their own requirements when it comes to a minimum credit score. A construction loan is different than any other type of loan because it is not backed by any government entity. FHA loans, VA loans, and even conventional loans with an LTV higher than 80% have the backing of the mortgage insurance that ensures the lender that they will be paid should the buyer default. There is no one backing up a construction loan, which means the lender is at risk for the entire amount if you were to default. In addition, banks keep construction loans in their own portfolio as there is not a huge secondary market willing to purchase these risky loans. For that reason, your credit score must be considered “excellent” in order to qualify.
Excellent credit typically means a credit score over 750. This is especially true if your loan amount is going to exceed the conforming maximum of $417,000, which is the limit for most loans, conventional or not. If your construction loan is less than $417,000, some lenders will be willing to go down to 700 or even 680 with compensating factors, but these lenders are few and far between. Compensating factors usually entail a low debt-to-income ratio; excessive reserves; or a very long and stable employment/income history.
In addition to your credit score, however, is your actual credit history. You must demonstrate the ability to pay your debts on time as well as responsible use of your available credit in order to qualify. This means that you should not have any late payments in the last 2 years, with minute exceptions made in extreme circumstances. In addition, any derogatory credit issues, such as foreclosures or bankruptcies should be at least 4 years behind you, if not more. Lastly, there should not be any collections, judgements, or federal debts on your credit report that are not resolved and have had some time since they occurred. Your credit history should be as clean as possible to ensure that you are a non-risky borrower.
Remember that the lender is also looking at your credit utilization rate. If you use all of your available credit and have nothing available, you are not a good credit risk. It is best to have no more than 20% of your available credit outstanding at the time of application for the construction loan.
The income requirements for a construction loan will vary from person to person. Generally, the bank is looking for a low debt-to-income ratio and stable income. This means if you have seasonal income or your income relies on bonuses and/or fluctuating commissions, you might have a harder time qualifying. This does not mean that people with fluctuating income will not qualify for the loan; it means you will undergo extensive scrutiny in obtaining the loan and will need to prove that your income has been stable for at least the last two years in order to qualify.
Lenders will need to see the following documents in order to qualify you for a construction loan, if you are employed:
- Last two years’ W-2s
- Most recent paystub covering the last 30 days of income
- Your credit report that shows all of your current debts
If you are self-employed, you will need to provide:
- The last two years’ full tax returns including all schedules
- Asset statements to prove the receipt of your income
The lender will also require a verification of employment (if you are employed) or a letter from a certified CPA (if you are self-employed) showing that you have been employed for the last 2 years at a minimum.
The lender will then use your income and the data from your credit report to determine your debt-to-income ratio. This is why the income requirements for every person is unique. If you have a large amount of outstanding debts, you will need a higher income to qualify than the person next to you that has very few outstanding debts and the same desired loan amount for the construction loan.
Overall, the goal is to have a front end (principal, interest, taxes, and insurance payment) debt ratio of no more than 28 percent of your gross monthly income. The back end ratio should be no more than 36 percent in most cases, which is the total debt that you pay every month in addition to the desired construction loan payment. These ratios pertain to the permanent financing which you need to secure in order to pay off the short-term construction financing. This will be a condition of your construction financing as the lender needs to know how you are going to pay off your construction fees once the house is completely built.
As with any loan, these requirements may vary by lender, but they are a general overview of what you could expect. If you are turned down by one lender, yet think you have the qualifications from above, it does not hurt to apply with another lender. Every lender creates their own construction financing rules, based on whether or not they are keeping the loans on their books or if they are selling them in the secondary market. If they are selling the loan, they will need to abide by the investors rules in order to ensure that the loan will be bought in the end.
Justin McHood is America's Mortgage Commentator and has been providing expert mortgage analysis for over 10 years.