Construction Loan Requirements: Why Construction Loans Are Hard?

Construction Loans 101: Step-By-Step, Costs and Pros & Cons

If you can't find the most appropriate home to buy, you might as well build your own house. Home construction financing is different from the mortgage one takes to move into an already-given property. In place of a 'mortgage', you get a 'construction loan' or 'construction mortgage.' Here are things to consider when obtaining a construction loan. Also, look at construction loan rates and home construction loan requirements.

Key Highlights

  • Short-term construction loans can be used to build a new home. 

  • Certain construction loans might become mortgage loans when your home is built. 

  • Contrary to traditional lenders, construction loan requirements are well above non-conventional mortgages of already existing homes.

What Are Construction Loans?

Construction loans are loans that finance the building of residential housing (a stick-built house), from the purchase of the land to the finished home. The common types are single draw-down construction loans with a one-year term — as the name suggests, finance the building phase and only the building phase — and a construction-to-permanent loan, which switches into a mortgage once construction is done. People who deal with a standalone construction loan usually get a separate mortgage to pay it off when the principal comes together.

You Can Use a Construction Loan to Cover Such Costs As:

  • The land

  • Contractor labor

  • Building materials

  • Permits

How Do Construction Loans Work? 

Usually, the initial term of a construction loan does not exceed one year or less, at the end of which the project must be completed. Construction loans are based on short timetables and the construction project's progress. 

Therefore, the lender must receive a construction schedule, detailed plans and a reasonably budgeted cost from you (or your building contractor). Accordingly, the lender will make the payments to the contractor in instalments during various stages of the project.

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What Is Included in a Construction Loan?

Basically, your construction loan can be used for everything you need to build your house. From a foundation, walls, and roof, this is what your construction loan will cover.

The Cost of Land

Only some people already own a piece of land, while others may have to purchase land for the new business.

The Foundation

On average, the cost of excavating and laying down the foundation and retaining wall is $34,850.

Construction Permits

Fees to be charged for building permits, impact assessments, water and sewage fee inspections, and other architecture and engineering assessment fees will be borne by you. Altogether, the NAHB figure is that permits cost $18,323.

Building Materials

Building a house starts from framing, insulation, drywall, flooring, cabinets, countertops, windows, and doors – the list is endless! A construction loan will cover the costs your builder will spend on procuring all essential items for your new home. This includes exterior fixtures, like paving your driveway and building a deck or a front porch.

Contractor Labor

The various trades – carpentry, plumbing, electricity, HVAC system set up, painting, and roofing will be invoiced separately at the end of their working day by your builder or the various contractors. The interest on your construction loan will also include that cost.

Major Appliances

The refrigerator and freezer, washer and dryer, dishwasher, fireplace, even your microwave – your home furnishings are not included in your construction loan coverage, though kitchen appliances are. 

That means you cannot just buy a couch and coffee table set, bedroom furniture with matching nightstands, or a dining room table and expect the construction loan to cover this debt as well.

Closing Costs

Your construction loan will typically have checkpoints you must complete, which include inspections, appraisals, loan origination fees, and title examinations.

Contingency Reserves

Like other construction loans, ours will provide flexibility in your budget to allow you to plan for unplanned costs. Storms rise in the price, or delays may slow your project. The fund is arranged to offset the cost.

Interest Reserves

Your construction loan may even include the amount you need to pay your interest until the completion of your home building.

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How Do You Qualify for a Construction Loan?

Construction loans are like mortgages, but the approval procedure for building a new house is more complicated. Here are four general steps:

1- Find a Licensed Builder:

The builder should be able to prove to the lender that they have the expertise to finish the house. Seek recommendations from friends who have successfully built their own homes. You will also get access to the NAHB's local home builders associations directory to find contractors near you. 

Similar to how you would evaluate existing homes before purchase, you should look at various builders to determine the combination of price and expertise that matches your requirements.

2- Find a Construction Loan Lender:

Call more than four experienced construction loan lenders and ask them about the details of their programs and processes. Smaller regional community banks and credit unions might be more willing to work with you if you have trouble finding a lender. Compare construction loan interest rates, terms and down payment requirements to ensure you are not leaving any money on the table.

3- Get Your Documents Together:

Your lender would often require a contract with your builder for a complete pricing and project plan. Please check with your builder for references and documents showing their business licensing. Furthermore, you are expected to submit the exact same financial documents as you do for a standard mortgage, such as paycheck stubs and income tax statements, which provide evidence of income, assets and employment.

4- Get Pre-Approved:

Having a construction pre-approval can give you an edge in terms of knowing how much money you can get for the project. This feature of the service can also be an important first step to avoiding paying for services from an architect and ensuring that the plans drawn up by you for your own home would be one you can afford.

5- Get Homeowners Insurance:

Even though you may not occupy the house at the moment, your lender will likely want you to have a prepaid homeowners' insurance policy that covers the builder's risks. In this method, if a fire breaks out in the middle of the construction or someone damages it after you have completed at least half of the work, you will be safe.

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Construction Loan Hard Costs

The construction loan usually has "soft costs", which are the cost of plans, permits, soil reports, and architect fees. Some construction loans also have "interest reserves" for paying the loan on the loan, but not all do. In addition to that, the construction loan will also cover the "hard costs" of construction. 

This encompasses everything, from the preliminary building process to the final completion with a certificate of occupancy, including demolition, framing, appliances, flooring, fixtures, landscaping, labour, etc. A 10% to 20% contingency for any overages is also generally required. Also, removable items, such as furniture and staging expenses, are rarely included.

Why Are Construction Loans Hard to Get?

As a rule, construction loans are more challenging to get than regular ones because of the nature of the project and the duration of the process. Most creditors will insist on a 680 credit score at least; this is more than what FHA, VA and conventional loans need. Banks usually want borrowers asking for construction loans to have a 20% down payment, so you may not qualify if you can't meet that requirement up front.

Is a Construction Loan Easier to Get Than a Home Loan?

Construction loans might be more challenging to get than housing loans. The lender takes additional risk since the property is unfinished, and the construction may fail. Construction loans often need a higher credit score and down payment. Construction loans can have higher interest rates than housing loans.

A construction loan can help people build or modify their ideal house despite the drawbacks. Borrowers may increase their chances of getting a loan by dealing with a reliable lender and preparing themselves beforehand.

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Are Construction Loan Rates Higher Than Mortgage Rates?

Since there is no house to act as security, construction loans usually bear higher interest rates than regular mortgages. These loans are high-risk because the lender's default resolution is unusual. Thus, you must meet specific conditions to get this loan, and the lender will examine your finances and the builder and contractor's work. You may need a builder contract, a timeframe for construction, and a specific budget to qualify for this financing.

Why Are Construction Loan Rates Higher?

Construction loans have variable rates that follow the prime rate, unlike mortgages. That means rate changes can raise or lower your monthly payment. Construction loans also have higher rates than mortgages. Their unbacked status contributes to that. Standard mortgages utilize your house as security; the lender can take it if you default. Due to their lack of choice, lenders perceive house-building loans as riskier. Construction loan interest rates are usually 1% higher than mortgage rates.

Can Construction Loan Interest Be Deducted from Taxes?

Yes, the interest paid on a construction loan can potentially be deducted from your taxes, with some limitations:

  • The purpose should be related to a trade or business activity. Building one's own home also does not qualify.

  • The amount of deductible interest is restricted if the construction loan is more than $1 million.

  • The property should be held for the production of income (rental property, business property, etc). You must apply them to something other than primary residences.

  • You must itemize your deductions to claim the interest. The standard deduction does not allow it.

  • Investment interest limitations may apply that further restrict the interest you can deduct.

What Is an Example of a Construction Loan Estimate?

An example construction loan estimate:

  • Loan amount: $300,000

  • Construction period: 12 months

  • Interest rate during construction: 7%

  • Origination fee: $3,000

  • Construction phase interest: $21,000 ($300k * 7% * 12 months)

  • Permanent loan amount after construction: $280,000

  • Permanent loan interest rate: 4.5% fixed 30-year mortgage

  • Permanent loan payment: $1,700 per month

If this is an investment/business property, the borrower can deduct $21,000 in construction interest over 12 months. The financing will become a $280k mortgage after completion.

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What Are the Advantages and Disadvantages of a Construction Loan?

Discover the pros and cons of construction loans and make informed decisions for your next building project.

Advantages:

Ability to Pay Construction Costs

One of the major benefits of construction loans is financing building costs. These loans may cover all building expenditures, including labour, supplies, and permits. They are designed for flexibility. With a construction loan, you don't have to worry about running out of money or stopping development.

Use Equity Again 

Reusing equity is another benefit of building loans. A construction loan might let you access its equity if you've invested in a property but wish to develop another structure. You can use the equity in your first home as collateral for a construction loan to fund your new project without putting up much cash.

Get Funding Easily

Conventional mortgages demand more approval than construction loans. These loans are meant to pay particular building or renovation costs. Construction loans are easier to get since the requirements focus more on the building process than the borrower's creditworthiness.

Construction Loan Drawbacks

Loan Terms May Be Problematic

Construction loans may have unfavourable terms. Small, three-year loans with repayment restrictions are common. Borrowers must make significant, ongoing payments to repay the loan, which may be problematic. After the building project, debtors must convert construction loans into permanent loans, which is complex and expensive.

Interest Rates May Rise

Due to their significant risk, construction loans have higher interest rates than regular mortgages. Lenders must limit risk and account for building delays and overruns. With greater interest rates, borrowers must budget for more outstanding monthly payments and more interest on the loan.

Scheduling May Affect Loan Repayment

Construction delays are common and may affect loan repayment. If construction is delayed, borrowers may need a loan extension, including fees and interest. The borrower may pay more if the loan's terms must be renegotiated owing to a major project delay.

Conclusion

Construction loans are a convenient way to become the owner of a home you dream of. Still, you should be very careful when considering the most effective way to deal with the principal. Before choosing, please get to know different lenders and find out their pros and cons.

FAQs

Is a construction loan and a home loan the same thing?

Since house loans are for expensive residences, they are usually costly. Therefore, the mortgage can be prolonged to 30 years. Unlike, needless to say, the case with home loans, home construction loans have a shorter term compared to the former.

How can I withdraw cash from my construction loan?

Ask your lender how you can get money from the issued amount. Some lenders offer monthly draws; others open a line only after a passed inspection. Ensure that you do not miss anything that might be needed to be able to draw money from the construction loan when the bills start coming in. Knowing this process — whether your contractor does or not — will help to prevent the delays that are often caused by insufficient funds.

What are the pros and cons of taking out a construction loan?

Construction loans have pros and cons. Such loans have higher interest rates than mortgage loans. A mortgage is a big payment, but a construction loan is issued in fractions as homebuilding develops. Construction loans are cheaper since they only demand interest payments until the house is constructed. Loan repayment conditions may also be better. 

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21 Feb, 2024

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