Building or remodeling your home from the ground up is a big job. Before you can even break ground, you need the proper financing. Unlike a standard mortgage loan, the self-build construction loan has more steps, requirements, and unique factors.
Keep reading to learn what you need to know about self-build construction loans before you get started.
Self-Build Construction Loans are Risky
Let’s start with the bad, first. Lenders look at self-build construction loans as risky – here’s why. When you take out a mortgage for an already built home, the lender has instant collateral. If you stop making your payments, the lender can foreclose on your home, taking possession of it. The lender then sells the home to make some or all of its money back.
A self-build construction loan provides you with funds to build the home from the ground up. The bank lends you money on something that doesn’t exist yet, which leaves them with no collateral. If you stop making your payments, the lender doesn’t have anything to take back and sell to avoid a total loss.
The Types of Construction Loans
Despite their risk, lenders do offer various types of construction loans. Lenders offer a single-close loan or two separate loans – one for the construction phase and another for the permanent home.
The single close loan combines the construction loan with the permanent financing, as you would get on an existing home. Construction financing is temporary and has a variable interest rate. You pay interest only on the amount you withdraw from the construction financing line while building the home. Once you have the occupancy certificate for the home, the single close loan turns into a permanent loan. Just like a standard mortgage, you choose the type of rate (fixed or variable) and the term for the permanent financing.
Some borrowers have trouble finding a single close loan or want the dual construction loans instead. With this option, you can use two different lenders for both loans. You start with the construction loan, which again is temporary financing to help fund the cost to build the home. Once you finish building the home, you must then refinance the construction loan into a permanent mortgage.
There are two downsides to the dual-close loan:
- You pay closing costs and fees on two loans and go through two closings.
- You can’t lock in your interest rate on the permanent mortgage until you finish building the home.
Higher Down Payments Required
Most lenders require at least a 20% down payment, if not more on construction loans. This helps them make up for the risk of default on this type of loan. With a 20% or higher down payment, the lender has at least some of the money sitting in their possession should you stop making payments.
You can shop around with different lenders to find one with a down payment requirement that you can accept. Unlike Fannie Mae, FHA, or VA loans, strict guidelines don’t exist. Lenders have their own guidelines based on what they can and are willing to risk.
Construction Loans are Temporary
Unlike your standard mortgage loan, construction loans are a temporary solution. The lender will determine the term based on the projected timeline to build the home. The lender involves itself in the planning process of building the home to make this decision.
During the construction phase, lenders don’t disburse the entire amount of the loan at once, like they do with a traditional mortgage. Instead, they have a contract with the builder outlining the disbursement schedule. Lenders typically pay in installments at various phases, which they determine. Many lenders make an initial disbursement to help the builder start the process and then set appropriate intervals after that point based on completion of the work.
With each ‘draw’ or disbursement, the lender makes, you owe interest on that portion. You don’t have to make principal payments until the loan becomes a permanent loan, or when you move into the home. It’s important to note that the lender disburses the money directly to the builder – not to you, the borrower.
Proving Your Ability to Afford the Loan
Just like any mortgage, you have to prove your ability to afford it. Unlike standard mortgage programs, though, lenders don’t have strict investor guidelines (FHA, Fannie Mae, etc.). You may find different requirements with each lender, which is why you should shop around.
In general, you can expect:
- At least a 680 credit score
- Maximum debt ratio allowance of 45%
- Requirement for stable income and employment (self-employment may be risky)
- Proof of no recent collections, judgments, or late payments
Lenders may also require you to have a large reserve account. This helps in the case of an emergency or unexpected expenses. Cost overruns occur often when building a home and lenders need to know that you can handle it. While many loans include a 15% – 20% buffer allowing for issues like this, many lenders require cash reserves on hand equal to 15% to 20% of the cost of building the home as well.
Finding a Self-Build Construction Lender
You may find that it’s a little more difficult to find a self-build construction lender. You have to think outside of the box. Check with your local banks, credit unions, and mortgage brokers. Online lenders often have more flexible guidelines too, giving you more options.
As you shop around, get pre-qualified or pre-approved with each lender. Lenders don’t do a hard inquiry on your credit with a pre-qualification, but it’s also not as solid as a pre-approval. If you apply for several pre-approvals within a few week timespan, though, the credit bureaus only hit your credit score for one inquiry, which only decreases it five points or so.
The important thing is that you shop around to find the right construction lender. Building a home is a big undertaking with many decisions. Having a solid lender on your side can help make the process less intimidating and hopefully help make it a smoother process for you.