Front Page Top Tips for Construction Loans
Want to build a new house, but have questions on how to finance it? Read on as we chat with our local mortgage expert to get answers.
If you’re wanting to build your dream home rather than buy an existing one, you may be surprised to learn that you won’t be getting a traditional mortgage. Instead, you’ll likely get a construction loan. We tapped the expertise of Cincinnati-based Ron Erdmann at Guaranteed Rate find out more about this loan type, how they work, and what to keep in mind before jumping in.
What are construction loans?
A construction loan is a loan used to finance the building of a home or another real estate project.
How do construction loans work?
Construction loans can help you build your dream home, says Erdmann. “A traditional home loan is based on the fair market value of the home and determined by the home’s condition in comparison to other recent sales,” he explains. “Construction loans are based on what the projected value of the home will be once the work is complete.”
Typically, traditional loans are paid out by a mortgage company for the cost of the home in one lump-sum at closing. In contrast, construction loans are paid in installments, or “draws.” A bank will pay the builder as various phases of the building process are completed. The total cost is transferred to you once the entire project is finished.
Why are new construction loans different?
When you borrow money to build a house, collateral isn’t there to back up the loan like there is in a traditional mortgage — at least, not yet. “With a traditional mortgage, if you default on your payments, the lender can seize your home,” says Erdmann. “With a home construction loan, the lender doesn’t have that option, so these loans are viewed as bigger risks.”
Things to consider:
Have a good team: Erdmann says it’s crucial to work with a good builder. “You need someone who’s experienced with budgeting and scheduling and who also has the ability to work well within those limitations,” he explains. “Make sure you do your research before applying for a loan, too, so you work with someone reputable.”
Have a good plan: According to Erdmann, you can also expect a thorough inspection of the architectural plans and your builder. “Because construction loans are on such a short timetable and they’re dependent on the completion of the project,” he says, “you need to provide the lender with a construction timeline, detailed plans and a realistic budget.”
Have a downpayment: For most construction loans, they’ll want you to contribute 20% of the cost of the total overall project. Example, if you purchase a lot for $200,000 and wish to spend $600,000 constructing the home, the total cost of the project is $800,000. So you’ll need to do a 20% downpayment, or $160,000, and finance the rest ($640,000).
Erdmann says construction loans can also be used for renovating your home, buying a fixer-upper, or building an addition onto your home. You’ll want to talk through details of those different types of construction loans with a trusted mortgage professional.