Are you thinking about building a home? Unless you have the cash on hand, you will need financing. Building a home is different than purchasing a home. You take out a different type of loan.
If you plan on building, it’s essential to know the difference between a new construction loan and a mortgage.
Construction Loans Temporary
A construction loan is a short-term loan used to finance a building or renovation. The loan is typically paid in installments as the work progresses.
Once the construction is complete, the loan can typically be rolled into a traditional mortgage.
Why Does Bank Pay in Installments?
A financial institution usually pays out the construction loan in a series of installments known as “draws.” This is paid as the work progresses. In other words, draws are paid on the completion of certain stages of construction, such as the foundation, framing, and final finishes.
Before releasing the draw, the bank or credit union will usually require an inspection of the work completed to ensure that it has met the agreed-upon standards.
The point of the draw is to assure the financial institution that the funds are going toward their intended purpose. It also ensures that construction is progressing as planned.
Who Does the Bank Pay?
In a construction loan, the financial institution usually pays the contractor directly for the work completed. The borrower will submit a draw request to the bank. This includes the contractor’s invoice.
The bank or credit union will inspect the work to ensure it has been completed. When satisfied, the bank will release the funds to the contractor.
How to Take Out a Construction Loan
There is a process for applying to and receiving a construction loan. You must supply the financial institution with a detailed construction plan and budget. The bank will want detailed plans, including drawings, specifications, and a budget.
Proof of income and assets must also be supplied. The financial institution will want evidence of your ability to repay the loan. You’ll also need to have a good credit score. A financial institution will check your credit history. You’ll need to pay a downpayment.
Banks want proof that the property will have value once the construction is completed. You’ll also need to show you’ve hired a reputable, experienced contractor.
And, finally, a bank will want to know if you have a plan for repaying the loan. If you’re the contractor, they’ll want to see if you’ve pre-sold the property. If you’re the homeowner, they want proof you plan to obtain a permanent mortgage.
Different financial institutions have other requirements.
Do Construction Loans Have Higher Interest Rates?
Construction loans generally have higher interest rates than traditional mortgages. This is because construction loans are deemed riskier than mortgages for completed properties.
The interest rate on a construction loan is usually a variable. It is based on a benchmark rate, such as the prime rate. In the past, it could have also been based on a LIBOR (London inter-bank offered rate), but that will be fazed out by June 2023. The new benchmark will be a SOFR (secured overnight financing rate). A margin for the bank is also added to the interest rate.
The margin is the lender’s profit, and it can vary depending on the risk assessment of the project and the borrower.
While traditional mortgages are 15 to 30 years, construction loans are short term. They’re usually one year or less. Because of the shorter terms, the interest rate is generally higher than the traditional mortgage rate. This compensates the financial institution for the added risk and shorter term.
Construction Loan Coverts to Mortgage
Once the construction is completed and ready for occupancy, the borrower can convert a construction loan into a mortgage. This process is known as a “take-out loan” or “end loan.” The take-out loan is a permanent mortgage that pays off the balance of the construction loan and provides long-term financing.
Construction Loan vs. Mortgage
Besides a construction loan being a short-term loan and a mortgage being a long-term loan, there are other differences.
With a traditional mortgage, the borrower receives the funds in one lump sum. This way they can buy their new home. But with a construction loan, the funds are dispersed in installments.
Payment is also different.
Once you’ve closed the loan on a traditional mortgage, you immediately start paying the principal and interest. But with a construction loan, you usually make interest-only payments while the building is under construction. But you only pay the interest on the drawn amount.
For example, you might have borrowed $750,000 to build your home. But in the first month, the draw is $75,000. You will pay interest on the $75,000. As you receive more draws, that amount will increase.
Owner-Builder Construction Loans
If you intend to act as your own contractor, you will probably not qualify for a construction loan. Instead, there is a variant called an owner-builder construction loan. And these are difficult to qualify for.
You must convince the bank you have the knowledge and abilities to build your home. A well-researched construction plan is imperative.
Construction Loans Short Term
A lot goes into building a home. Hiring the right contractor and picking the lot is just part of it. In addition, acquiring the right financing is imperative. Construction loans are different than traditional mortgages. Talk to a financial advisor and determine if building is right for you.
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