Before my husband and I broke ground, I never understood how people could afford to build a house. I knew you could take out a loan to pay for construction, but what kind of loan? For how much? For how long?
I was overwhelmed by all the details when I first started, but thanks to a super patient loan officer—and plenty of conversations with banks from the day we bought our land to the day we closed on our construction loan, three years later—I’ve learned a lot and hope to demystify the process a bit for anyone else who’s looking to build a house.
Before I get any further, I should make it clear that I am not a real estate or banking professional, and my personal experiences in this article should not be construed as legal or financial advice. If you want to get a construction loan, please consult with qualified local professionals (such as real estate brokers, loan officers, lawyers and the sort) for help with securing the right loan in your specific situation.
If you’ve been Googling construction loans but all the information is making your head spin, consider this sort of a “101 of Construction Loans” to help you wade through the murky waters of construction financing.
While my experience is limited to my own situation, this is how I’d explain the process to a friend. It’s what I believe every first-time borrower should know before walking into a bank.
Construction projects often end up costing more than originally budgeted. From changes in building materials prices to modifications in the floor plan, it’s common for the total price to exceed initial estimates. When this happens, you may need to increase your construction loan amount to fully fund the project. Here are some tips on how to get approval for more financing if your build goes over budget.
Why Costs Can Exceed Estimates
Several factors frequently cause construction budgets to be off-target:
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Design changes It’s very common for homeowners to alter aspects of the floor plan or make other design modifications during the building process. These changes can increase costs, especially when they expand the home’s square footage or upgrade to more expensive finishes.
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Materials price increases Lumber steel and other commodity prices can fluctuate significantly, causing material expenses to be higher than the original quotes. Supply chain issues can also lead to shortages and price hikes.
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Labor shortages: A lack of available skilled tradespeople in your area may mean paying premium rates for in-demand workers like framers, plumbers, and electricians.
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Weather delays: Inclement weather can halt construction for days or weeks, extending the timeline and increasing labor, material storage, and financing costs.
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Incorrect estimates: In some cases, contractors simply underestimate the true cost of the project. Many homeowners get “sticker shock” when the final price comes in.
Requesting More Funds From Your Lender
If it becomes clear your build is going over budget, the first step is to speak with your construction lender about increasing your loan amount. Most lenders understand that cost overruns occur and will work with borrowers on getting extra financing when needed.
Here are some tips for requesting more funds:
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Act early: Don’t wait until the 11th hour when funds are completely depleted. Give your lender lead time to process the request.
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Document the overage: Provide the lender with details on exactly what is causing the budget shortfall. Change orders, contractor invoices, and other paperwork will help support the request.
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Show how you’ll repay it: The lender needs to be confident you can handle a larger mortgage payment. Supply documentation like bank statements, proof of income, and information on assets or down payment sources.
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Be ready to pay fees/costs: There may be charges associated with increasing the loan amount, so ask the lender to explain any costs upfront.
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Consider collateral: If there is equity in the land or you have other assets like a second home, this additional collateral can help boost loan approval chances.
Alternatives If Your Lender Declines
Unfortunately, sometimes lenders will deny requests for construction loan increases due to borrower qualifications, appraisal issues, or other limiting factors. If you get turned down, here are some alternative options to explore:
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Larger down payment: Putting more money down reduces the amount that needs to be borrowed. Look at cashing out investments, a home equity loan, gift funds from family, or other sources.
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Construction loan from another lender: Check if a different lender may be more flexible on loan-to-value and qualifications to get approved for a larger amount.
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Home equity loan after completion: If approved, finish construction by bringing in your own cash temporarily. Then get a home equity loan against the completed property to replenish funds.
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Alter floor plan/finishes: Look for design changes that will bring the price back into budget while maintaining most of what you want in the home. Value engineering is key.
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Owner-builder financing: In some cases, acting as your own GC without a construction loan may provide more financing flexibility. But beware of the risks.
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Delay/stage construction: Break ground with phases you can pay for now. Delay more expensive portions until you’ve saved up or the budget improves.
When Higher Loan Amounts May be Possible
While every situation is different, here are a few scenarios where getting approval for more construction financing is more likely:
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You have an excellent credit score, stable income and employment, and a low debt-to-income ratio.
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There is significant equity in the land if you already own the lot.
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The cost overruns are due to upgrades that increase the home’s value, like additional bedrooms.
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You are able to put more money down to reduce the amount borrowed.
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You have other major assets like stocks or a second home as collateral.
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Interest rates have decreased, qualifying you for a lower payment at the same loan amount.
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The lender is able to re-appraise the property based on completed work and justify the higher loan.
The bottom line is cost overruns are common in construction. Careful planning and communication with your lender can go a long way towards getting the extra funding needed to complete your project. Explore all options and be ready to compromise or get creative if requesting a larger construction loan proves difficult.
The bank will order an appraisal
The bank will look at your land and make sure it falls within their lending guidelines. (Some banks will only work with lots that have existing utility access, for example, or lots under a certain size.)
They’ll ask for a complete set of construction drawings and order an appraisal of the finished value of the house. It might seem impossible to appraise a house that doesn’t yet exist, but the process is fairly straightforward.
The appraiser gets comps from nearby properties. They drive to your lot to assess its location and features. They study your construction drawings and make note of the size, number of rooms, number of fixtures, quality of finishes, and the type of roof, siding, windows, doors, and driveway you will have—everything that goes into building your house.
From all that, they can estimate what the finished value of your property will be.
You only make interest payments during construction
When you close on a construction loan, you haven’t actually borrowed any of the money yet, so no payments are due. But then your builder excavates the site and pours the footings. A draw is made from the loan to pay your builder, and you start making payments.
While your house is being built, you only pay interest on the portion of the loan that’s been drawn by your contractor.
Let’s say you’ve drawn (or borrowed) $50,000 of your $400,000 construction loan.
The interest rate on your construction loan is 6 percent. That 6 percent is an annual number, and 6 divided by 12 is 0.5, so your monthly interest rate is 0.5 percent.
You’ve borrowed $50,000 so far, so 0.5 percent of that is $250. That’s going to be your interest payment next month.
If you draw another $25,000 next month, then your interest payment the following month will be $375, because you’re paying 0.5 percent on the total amount you’ve borrowed to date. The worst month will be the month your builder finishes the house, because the final payment will be drawn.
At that point, you’ll have likely borrowed the full amount of your construction loan, so your payment will be 0.5 percent of $400,000, or $2,000.
Once you convert to a permanent mortgage, that new loan will pay off the construction loan, and you’ll begin making mortgage payments (typically a month or two after).
Use A Construction Loan To Build A House?
FAQ
What happens if you run out of money on your construction loan?
What happens if you go over budget on a construction loan?
Should I pay off my land before you build?
Can you convert a construction loan into a mortgage?
Can you get a construction loan for a new home?
Construction loans are specifically designed to finance new home construction. Homeowners who want to renovate an existing home have other options, such as home equity loans, but these ‘second’ mortgages tap into the current home’s value for renovation projects.
How much money do you need for a construction loan?
Borrowers typically need a down payment of at least 20% for a construction loan, but this can vary by lender. You should have enough income to cover payments on your current debts and the new construction loan. Lenders typically require a DTI ratio no higher than 45% for construction loans.
Are construction loan rates higher than mortgage rates?
Construction loan rates are typically around 1 percent higher than mortgage rates. With a construction loan, you typically don’t receive the full loan amount upfront. Instead, you receive the loan in installments to pay for the construction work in stages. Michael Gevurtz, CEO of Bluebird Companies, explains how this works:
What happens if interest rates are lower than my construction loan?
If interest rates at the time your home is completed are lower than the interest rate on your construction loan, you can pay nominal cost to have your interest rate reduced (some restrictions apply). This option is only available once your home is completed. With this flexibility you can have your cake and eat it too!