Building a new home is exciting. You get to customize an existing home plan or create your very own design to get a home that is unique and meets your needs. But when building your own home, a conventional mortgage just won’t cut it because there is no home to use as collateral. As such, you will have to apply for a construction loan.

Construction Loans Are Short Term & Have Higher Interest Rates

A construction loan is a short term loan used to cover the costs of building your own home. Because construction loans are provided to you through a series of advances as you move further along in the home’s construction, interest rates will be higher.

There Are Two Types Of Construction Loans

When you apply for a construction loan, you must be aware that there are two different types: Construction to permanent and stand alone.

Depending on your lender and your credit history, your construction loan can be automatically converted into a permanent conventional loan that you will pay off. If not, you will have to reapply for a loan. Technically speaking, you will be refinancing and have two loans in one. If you choose not to convert your construction loan into a conventional mortgage, you can choose to pay off the balance in a lump sum.

A stand alone construction loan is two separate loans—one for the home’s construction, and a mortgage to pay off the debt from the construction loan. This type of loan is good if you already have a home you can sell for more money to use later. You can make a smaller down payment, but you cannot lock in a maximum mortgage rate and you will pay two sets of closing and other fees.

Qualifying For A Construction Loan

There is a lot of trust needed between all parties involved in a construction loan if it is to work—the borrower, the lender, and the builder. Why? Lenders tend to be wary of these loans since the home is not yet constructed and they can only operate on the assumption that the home will be well built and have value when completed. If the lender does a poor job or property values in the area fall, then that will have been a bad investment for the lender.

Because of this, there are strict qualifications for those borrowers who wish to get a construction loan:

  • The builder must be qualified with an established reputation of building good homes and meeting construction deadlines. So do your research.
  • You will need to give the lender very detailed home specifications including floor plans, a comprehensive list of building materials, a construction timeline, et cetera. Details can include everything from how high a window is to what type of shingles will be used.
  • The proposed home’s value must be appraised by an appraiser, who will examine the blueprints and specifications of the home and compare it to similar houses in the area.
  • The ability to put down a large down payment, as some lenders require a minimum of 25% to help ensure that you are invested in the construction of the home.
  • You must have good credit and prove that you will be able to afford the payments you will have to make on the loan.

If you are thinking of new construction, consult with your bank and lender to determine if you qualify. They can help guide you through the process and answer any questions you may have.

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The above information is for educational purposes only. All information, loan programs and interest rates are subject to change without notice. All loans subject to underwriter approval. Terms and conditions apply. Always consult an accountant or tax advisor for full eligibility requirements on tax deduction.