If you are looking to build your new home rather than buy an existing property, you’ll need a construction loan. But while these loans tend to have interest-only payments while the home is being built, they also tend to have higher interest rates.
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What is a construction loan?
A construction loan is a type of mortgage designed for people who plan to build a new home.
Construction loans aren’t set up in quite the same way as a regular mortgage. Instead, the lender considers the total amount you need to borrow in order to pay your builder, and then breaks down the full amount into separate payments, called draws. These draws are usually split up over project milestones. For example, your contractor might get a payment after finishing the home’s planning and foundation.
Most lenders will only expect you to pay the interest due on the amounts that have been drawn. Your full principal and interest payments won’t begin until your home is finished. But what happens when your home is finished depends on what type of construction loan you have.
- Construction-to-permanent loan. When the construction is complete, your construction loan will revert to a regular mortgage with full principal and interest repayments.
- Construction-only loan. When the construction is complete, the full balance of the loan becomes due. You’ll need to get a second mortgage to pay off the construction mortgage.
Who needs a construction loan?
Construction loans are suitable for any borrower intending to build a new home on a vacant block of land. They can be used to buy land and build a home, or to build a home on land you already own.
Construction loans can also be used to renovate existing homes, though some lenders will refer to this as a renovation loan.
Do I have to use a licensed contractor to construct my home?
The vast majority of banks and lenders will require you to use a licensed contractor. However, there are some lenders that will allow you to build your own home as an owner-builder. This is ideal if you’re a qualified tradesperson or if you’re a licensed contractor.
What is an owner-builder mortgage?
An owner-builder mortgage is designed for those people who want to build their own homes without the help of a licensed contractor. As banks and lenders use the property as security for your mortgage, many of them consider owner-builder mortgages to be high risk. For this reason, many banks and lenders will not accept applications for these types of home loans.
Additionally, those lenders that do offer owner builder mortgages may agree to pay for a smaller percentage of the total cost, which means you’ll need a larger amount saved up.
What if the building contract changes?
Unexpected hiccups in the construction process or upgrades to tiles, paint, bricks, roofing and other customizations as you build can increase the price of your home. In some cases, you may be able to approach your lender and ask for an adjustment to your mortgage amount to cover the difference — but you shouldn’t count on it. It’s a good idea to have more cash than you think you’ll need before you start building so that you’re able to cover unexpected costs out-of-pocket.
To help prevent price surprises, get your building contract completed and finalized before sending it to your lender.
How to choose a construction loan
Compare loans based on:
- Interest rates. Because construction loans are generally interest-only, this will determine your payments while the home is being built.
- Fees. This includes standard closing costs and extra administrative fees that are sometimes added on to construction loans.
- Construction terms. You’ll want to confirm what construction terms your loan will offer, including how long you have to build the home.
- Eligibility criteria. Due to the inherent risks involved for the lender, construction home loans are normally only offered to borrowers who have very good credit histories. The exact credit score will vary from one lender to another, so shop around to find a lender that fits your needs.
- Down payment. Construction loans will often require a larger down payment of 20% to 30%.
6 tips to follow when building a home
- Get preapproved. Always approach your bank or mortgage broker about a preapproval for your construction loan before making plans. This will let you know exactly how much you’re able to spend on your land and your construction costs as a combined total. This is also a great way to ensure you don’t go over budget.
- Check your contractor’s license. Each state has a slightly different process for this, but you’ll likely be able to look up your contractor on your state’s .gov website.
- Check your contractor’s qualifications. You’ll also want to make sure that your contractor is fully insured, has good reviews and that you like previous houses they’ve worked on.
- Get an accurate estimate of how long it’ll take to build. Ask your contractor how long the home will take to build. If possible, get it in writing.
- Find out how draws are made. Check with your bank to find out how draws are made. Does the home need to be inspected after each milestone? Can you submit everything online, or will you need to mail in paperwork after each milestone?
- Get insurance. You’ll want to make sure that your home is insured both as it’s being built and when it’s finished.
Building your own home can mean you get everything exactly the way you want it, and with a construction loan you remain in control of the building process at every stage. But you’ll need good credit and a hefty down payment. If you aren’t able to qualify, you’ll need to either wait to build a home or compare other mortgage options and buy a home that’s already built.
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