Constructing a new home can be an exciting yet challenging process. One of the most important factors lenders consider when approving construction loans is the borrower’s debt-to-income (DTI) ratio. This measures how much of your gross monthly income goes toward paying debts. Understanding how DTI works for construction loans can help you get approved and stay on budget while building your dream home.
What is Debt-to-Income Ratio?
Your DTI ratio compares your total monthly debt payments to your gross monthly income before taxes and other deductions. To calculate your DTI, you divide your total monthly debt payments by your gross monthly income.
For example, if your total monthly debt payments equal $2,000 and your gross monthly income is $5,000, your DTI would be 40% ($2,000 / $5,000 = 04 or 40%).
A lower DTI ratio indicates you have more available income to make your debt payments, A higher ratio means you have less wiggle room in your budget for additional debts
Typical DTI Requirements for Construction Loans
Most lenders want to see your DTI ratio at 43% or less when applying for a construction loan backed by the Federal Housing Administration (FHA). The FHA insures construction loans and mortgages, making them less risky for lenders.
For FHA construction loans, you’ll typically need a minimum down payment of 3.5% if your credit score is 580 or higher. With a credit score between 500 and 579, you’ll likely need at least 10% down.
Outside of FHA programs, each lender sets their own DTI requirements for construction loans. Many aim to keep your ratio below 45%. But maximum allowable DTI can range from 40% to as high as 50% depending on the lender.
Those with higher credit scores and lower DTIs tend to get approved more easily and may qualify for lower interest rates. Shop around with multiple lenders to compare rates and requirements.
How DTI Works During the Construction Phase
Determining DTI for construction loans gets tricky because you’ll likely need to carry the mortgage on your current home during the build. This essentially doubles your housing payment temporarily.
Lenders realize these unique circumstances. So they may exclude your current mortgage payment when calculating DTI for construction loan approval.
For example, let’s say your current mortgage payment is $1,500 and the future payment on your new construction loan is estimated at $2,000. That’s a total of $3,500 for both homes.
Excluding your current mortgage, your DTI would only include the estimated $2,000 payment on the construction loan. This allows you to meet a typical 45% DTI limit more easily.
However, lenders still want to see you can afford both housing payments together when determining the loan amount you qualify for.
Tips for Managing DTI During Construction
Here are some tips to keep your DTI in check so you can get approved and manage both housing payments:
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Pay down debts before applying – Reducing credit card balances and other debts can lower your DTI.
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Make a larger down payment if possible – Putting down 20% or more reduces loan amounts so you qualify for more.
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Sell your current home first – Then rent until the new build is complete to avoid overlapping mortgages.
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Refinance your current mortgage – Take cash out to pay down balances and possibly reduce your current housing payment.
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Use a cosigner – Adding someone with good credit and income can improve your DTI.
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Purchase mortgage insurance – Paying PMI premiums means you can put down less money upfront.
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Consider an adjustable rate – Your initial monthly payments may be lower compared to a fixed-rate loan.
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Finance the land separately – This keeps the construction loan balance lower so payments are less.
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Make interest-only payments – Pause principal payoff until construction is complete to lower payments temporarily.
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Tap home equity – Use a HELOC or cash-out refinance to access equity that can cover some construction costs.
Other Key Factors Beyond DTI
While DTI is critical, lenders also weigh other factors when approving construction loans, including:
- Your income and assets
- Credit history and scores
- Down payment amount
- Property appraisal and plan
- Builder reputation and expertise
- Contingency funding availability
- Collateral assets offered
Meeting lenders’ DTI requirements for construction loans is certainly possible with some preparation and planning. By understanding how lenders calculate and consider your ratio, you can take steps to keep it within an acceptable range and get approved to build your dream home.
How To Get A Loan For Construction
Acquiring a construction loan starts with pre-approval for a loan. This will give you an idea of how much money you can borrow and what your monthly payments will be during construction. During the pre-approval process, you will need financial documentation including your most recent tax returns, pay stubs, bank statements, and investment statements. Gather any documentation that shows your assets and proof of down payment. Make sure you have all your loan requirements ready to show your lender. Once you have your pre-approval for a loan you need to find a qualified builder.
The lender will typically have a list of approved builders that they work with. If you want to use a builder that is not on the lender’s list, you may be able to provide the lender with additional documentation to have your builder approved. Make sure the builder is licensed and insured. It is also a good idea to get references from previous clients before committing to a builder.
Once you have a builder you need to get a construction loan estimate. The builder will need to provide an estimate that shows your lender the cost of the project, and the length of time it will take to complete. You will also need to tell the lender the type of construction loan you are interested in.
Once the lender approves your loan it is time to sign the loan documents. These documents will outline the terms of the loan, such as the interest rate, the repayment schedule, and the fees.
After the loan documents are signed you can start construction on your home.
How Does A VA One Time Close Construction Loan Work?
VA One time close construction loans work in the same way conventional one time close construction loans work. Once you have been approved for a VA one-time close construction loan, the lender will disburse the funds to the builder in a series of payments or draws. The number of draws and amount of each draw will be determined by the lender and builder. The first draw will usually be used the cover the cost of the land. Remaining draws will be used to cover the cost of construction as the builder completes each phase of the project.
Once the home is complete, the construction loan will be converted to a permanent mortgage. The terms of the mortgage will be agreed upon at the time of the initial loan approval.
When your construction loan is converted to a permanent mortgage, you may be able to refinance the loan to take advantage of lower interest rates, if lower rates exist. However, you should be aware that there may be closing costs associated with refinancing.
How to Calculate Your Debt to Income Ratios (DTI) First Time Home Buyer Know this!
FAQ
What is a good debt-to-income ratio for construction loan?
What is the loan to value ratio for construction loans?
What is the max debt-to-income ratio lenders will usually accept?
What is the minimum FICO score for a construction loan?
How much money do you need for a construction loan?
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. Down payment of at least 20%. Borrowers typically need a down payment of at least 20% for a construction loan, but this can vary by lender.
What is a good debt-to-income ratio for a construction loan?
The ideal debt-to-income ratio for a construction loan can vary, but should never exceed 45 percent. Is it cheaper to buy or build a house? Usually, it is cheaper to build than to buy a home.
What is the loan-to-value ratio for a construction loan?
Like a normal mortgage, the Loan-to-Value ratio is key for understanding how a construction loan works. This ratio is simply referring to the % of your home that you will own and what % is being borrowed. If you buy a home and make a 10% down payment, as an example, the Loan-to-Value is 90%.
How do you calculate a debt to income ratio?
It takes into account all of your minimum monthly debt payments—this includes housing costs, car loans, credit cards, personal loans and student loans. The simplest way to calculate your DTI ratio is to divide your monthly debts by your gross monthly income, and then multiply by 100. DTI = Monthly Debt Payments / Gross Monthly Income x 100