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As a first-time homebuyer, the prospect of building your dream home from the ground up can be incredibly exciting However, the process of obtaining financing for new construction can also seem daunting if you’ve never done it before. That’s where construction loans come in
Construction loans provide the financing needed to build a new home on property you already own or plan to purchase. They work differently than traditional mortgages in a few key ways. If you’re considering a construction loan for your first home, here’s what you need to know:
What Exactly is a Construction Loan?
A construction loan is a short-term loan used specifically to finance the building of a new home. The funds can cover purchasing the land, paying contractors, obtaining permits, buying materials, and more.
Construction loans are usually structured as revolving lines of credit, with the lender disbursing funds in multiple installments as certain stages of construction are completed. This ensures the work stays on track and prevents borrowers from defaulting with partially-finished homes
After the home is built, the construction loan can either be converted into a permanent mortgage or paid off entirely so you can obtain long-term financing.
Construction vs Traditional Mortgages
There are some key differences between construction loans and traditional mortgages that first-time homebuyers should understand:
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Shorter terms: Construction loans typically have terms of 6-24 months, while mortgages are 15-30 years.
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Variable rates: Construction loans often have adjustable interest rates, while mortgages usually have fixed rates.
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Collateral: Mortgages are secured by the completed home, while construction loans are riskier for lenders. You may need to put up additional collateral.
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Payments You only pay interest on the funds disbursed with a construction loan, unlike a mortgage where you pay down principal plus interest each month
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Approval process: Getting approved for a construction loan often involves more stringent credit/income requirements, as well as presenting extensive plans and specifications.
Construction Loan Interest Rates
Interest rates on construction loans tend to be higher than rates for traditional mortgages. This accounts for the increased risk lenders take by financing unfinished homes.
According to current market rates, first-time homebuyers can expect to see construction loan rates in the range of 5-6% on average. However, your specific rate depends on your financial profile, the loan amount, and market conditions. Maintaining excellent credit can help you secure the most favorable rate.
How Do Construction Loans Work?
While the process varies slightly by lender, here are the basic steps involved with getting a construction loan as a first-time homebuyer:
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Find and purchase land. Construction loans can include the cost of the land itself if you buy it upfront as part of the project.
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Get pre-approved. You’ll undergo credit checks and assessment of assets/income like any mortgage, but with stricter requirements. Be ready to provide comprehensive plans and a detailed budget.
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Submit plans for approval. Your lender will review your home plans to make sure they meet all requirements and are approved by your local permitting office.
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Close on the loan. This involves signing all loan documents and paying fees/closing costs (2-5% of the total loan amount). At this point, construction can begin!
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Receive disbursements. As certain stages of construction are completed, your lender will release funds to pay your builder and subcontractors. Inspections ensure work is progressing properly.
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Construction completes. Once local authorities issue a Certificate of Occupancy, construction is considered officially complete.
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Pay off or convert the loan. You now have the option to pay off the construction loan or convert it into permanent financing. This may require a second application process.
What Do Construction Loans Cover?
Typical expenses covered by a construction loan include:
- Land acquisition
- Fees for contractors, architects, engineers
- Building permits and surveys
- Materials and labor
- Interest payments
- Contingency reserve (10-20% of total costs)
- Closing costs and loan fees
Construction loans give you access to all the necessary capital so you don’t have to finance the project piecemeal.
Construction Loan Requirements
As a first-time homebuyer, you may need to meet stricter requirements to qualify for a construction loan compared to a traditional mortgage. Typical requirements include:
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Credit score: 680+ is generally required, although some lenders may want scores of 720+
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Down payment: Often 20-25% of total costs, but as low as 5% with some loan programs
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Debt-to-income ratio: Usually a max of 43%, meaning your total monthly debt is less than 43% of gross monthly income
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Job history: At least 2 years of steady employment in the same field
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Loan-to-value ratio: The loan amount will be limited based on the appraised value of the land/completed home
Meeting these requirements demonstrates you’re financially stable enough to take on the risks of new construction. Having an excellent credit score is key.
Types of Construction Loans
There are a few varieties of construction loans to be aware of as a first-time homebuyer:
Construction-to-Permanent: The most common type, this starts as a short-term construction loan and converts to a fixed-rate mortgage once building is finished. This allows you to lock in your long-term rate upfront.
Construction-Only: You receive construction financing, then must obtain separate permanent financing after the home is complete. This involves two loan applications and two closings.
Renovation Loans: These loans combine purchase financing with funds for renovating an existing home. The loan amount is based on the home’s expected value after renovations are complete.
Finding the Best Construction Loan Lender
As a first-timer, finding the right lender for your construction loan is key. Compare multiple lenders and look for these features:
- Experience financing construction projects
- Competitive interest rates
- Low origination fees
- Good reputation with local builders
- Flexible draw schedules
- Willingness to fund 100% of construction costs
- Seamless conversion to permanent financing
A lender well-versed in construction lending can walk you through the unique process and create the optimal loan package to bring your dream home to life!
Pros and Cons of Construction Loans
If you’re on the fence about obtaining a construction loan as a first-time homebuyer, weighing the pros and cons can help make your decision:
Pros
- Build a custom home to your specifications
- Potentially higher home value after construction
- Lock in interest rates for permanent financing
- Stage payments to coincide with construction milestones
Cons
- Higher interest rates than traditional mortgages
- Stricter lender requirements
- No guarantee home value will equal construction costs
- Potential for delays, budget overruns, and other issues
For many buyers eager to construct their ideal home, the pros outweigh the cons. As long as you choose an experienced lender and realistic project scope, a construction loan can be a great option.
Alternatives to Construction Loans
Some other ways first-time homebuyers can finance new construction include:
- VA loans – Require zero down payment for qualified veterans
- USDA loans – Zero down loans for properties in rural/suburban areas
- Renovation loans – Finance purchasing and renovating an existing home
- Manual disbursements – Release smaller sums manually using personal loans or your own capital
However, construction loans provide the simplest all-in-one financing solution in most cases.
The Bottom Line
While the process differs slightly from traditional mortgages, construction loans give first-time homebuyers an opportunity to build a customized home. By understanding construction loan specifics, requirements, and alternatives, new homebuyers can make informed financing decisions. With proper planning and budgeting, construction loans provide an efficient means of financing your dream home.
FHA construction loan requirements
The qualifying requirements for an FHA construction loan are similar to those for standard FHA loans, but with a few additions.
To qualify for any FHA loan, you’ll need to meet the following criteria, at minimum:
- Credit score: At least 580, or as low as 500 if putting down at least 10 percent
- Debt-to-income (DTI) ratio: No more than 43 percent (with some exceptions)
- Down payment: 3.5 percent with a credit score of at least 580, or at least 10 percent with a credit score between 500 and 579
- Loan limits: No more than the FHA loan limits for the year; for 203(k) loans, no more than the FHA loan limits, the home’s after-renovation value plus improvement costs or the home’s after-renovation value, whichever is less
- Mortgage insurance: Upfront and annual FHA mortgage insurance premiums, paid for the life of the loan in most cases
- Occupancy: Primary residences only
On top of these requirements, FHA construction loans require satisfactory documentation detailing the construction or renovation project, including information about the contractor you plan to work with. For a standard 203(k) loan, you’ll be assigned a 203(k) consultant to estimate the remodeling or repair costs.
Whether you get a construction-to-permanent or rehab loan, the work will also be subject to inspection as the project progresses.
How does a construction loan work? Construction loans aren’t like regular mortgages. They typically last for one year, during which time the lender releases payments, usually directly to your contractor. The lender enlists an inspector to evaluate the project at various stages, and releases more funds once everything checks out. Once construction is finished, the loan either converts to a traditional mortgage or the borrower obtains a mortgage to pay it off.
- FHA construction-to-permanent loan: An FHA construction-to-permanent loan finances the ground-up construction of a home — including the purchase of the land or lot — then converts to a regular FHA mortgage. This is also known as a one-time or single-close loan; you won’t have to pay closing costs for two separate loans.
- FHA 203(k) rehab loan: An FHA 203(k) loan finances the cost of buying an existing home plus renovations and repairs. There are two types of 203(k) loans: a standard 203(k) for renovations costing $35,000 or more; and a limited 203(k) for smaller-scale, less expensive projects. Either option allows you to obtain one loan to buy and fix up a home, instead of two loans.
Construction Loans: What They Are and How They Work (IN DETAIL)
FAQ
What is the lowest down payment for a construction loan?
What is the lowest credit score for a construction loan?
Is a construction loan easier to get than a home loan?
Should I pay off my land before you build?
What is a construction loan?
A construction loan is short-term financing that can be used to cover the costs associated with building a house, from start to finish. Construction loans may cover the costs of buying land, drafting plans, taking out permits and paying for labor and materials.
Can a construction loan help a first-time homebuyer?
Home » First-Time Buyers » A First-Time Buyers Guide to Understanding the Construction Loan Process First-time homebuyers can use construction loan to help finance their home. Building that perfect home you’ve sketched on napkins for years can be an exciting, yet stressful experience, particularly if it is your first time building a home.
How do construction loans work?
Constructions loans work differently than mortgages. A construction loan is a short-term — no more than 12 months — financial commitment by a lender to finance the cost of building a home. This loan often includes the cost of acquiring the lot. You can expect to pay a portion of the funds, usually 10 percent to 20 percent, as equity.
How do construction-to-permanent loans work?
For construction-to-permanent loans, the home will serve as collateral for the mortgage once construction is complete. Getting approval for a construction loan might seem similar to the process of obtaining a mortgage, but getting approved to break ground on a brand-new home is a bit more complicated.