The Complete Guide to Types of Building Loans

Building a new home or commercial property can be an exciting yet daunting undertaking One of the most important steps is securing financing to pay for land, construction costs, and other expenses. Building loans are specifically designed to fund construction projects from start to finish. There are several types of building loans to choose from, each with their own pros and cons This comprehensive guide will walk you through the most common types of construction loans available.

Overview of Building Loans

A building loan also known as a construction loan, is a short-term loan used to finance the construction of a new residential or commercial building. The loan covers hard costs like materials and labor as well as soft costs like architectural fees, permits, and insurance.

Unlike a traditional mortgage, building loans provide incremental disbursements of funds during the construction phase based on work completion milestones This protects both the borrower and lender by ensuring the value of disbursements matches the completed work

Once construction is finished, the loan is either paid off or converts into permanent financing with a traditional mortgage. Building loans typically have variable interest rates and last for 6 to 24 months.

Standalone Construction Loans

A standalone construction loan only finances the building phase. It does not convert into long-term financing. This type of loan generally has a 6 to 12 month term with interest-only payments during construction.

Benefits:

• Shorter term and construction-only focus
• Interest rates may be lower than construction-permanent loans
• Allows shopping around for permanent financing after construction

Drawbacks:

• Need to requalify and reset terms for permanent financing
• Two rounds of closing costs for construction loan and permanent mortgage

Standalone construction loans work best for borrowers who want flexibility in their long-term financing options and are confident they will requalify for a mortgage once the home is built.

Construction-to-Permanent Loans

With a construction-to-permanent loan, the construction loan converts into a traditional mortgage once building is complete. This avoids the need to reapply and reset terms on new financing.

There are two main types of construction-to-permanent loans:

• Single-close loan: Construction and permanent financing are bundled into one loan with a single closing. The interest rate converts from adjustable to fixed rate once building is done.

• Two-close loan: The construction loan and permanent mortgage are separate loans with two distinct closings. This allows shopping around for the mortgage.

Benefits:

• One-and-done financing with no need to requalify later
• Single-close option has lower closing costs
• Interest rates may be better than standalone construction loans

Drawbacks:

• Less flexibility in permanent financing options
• Potentially higher interest rates than shopping separately for mortgage
• Loan limits may require second loan if construction costs escalate

Construction-to-permanent loans are a good fit for borrowers who value one-stop financing and do not need to shop mortgages later.

Land Acquisition Loans

If you need to purchase land before building, a land acquisition loan covers the upfront costs. This loan can be rolled into a construction loan or mortgage later.

Benefits:

• Finance land purchase separately from construction
• Avoid tying up capital needed for building costs
• Can be converted into construction loan and mortgage

Drawbacks:

• Additional loan underwriting and fees
• Risk of rates or qualifications changing before permanent financing

Land acquisition loans provide flexibility for those looking to buy land now and sort out construction details later.

Owner-Builder Loans

Owner-builder loans are offered to homeowners who want to act as their own general contractor. Loan qualifications can be stricter due to the higher-risk nature.

Benefits:

• Allow owner-builders to access construction financing
• Potential cost savings by acting as own contractor
• More control over building schedule and process

Drawbacks:

• Stricter loan requirements like high credit scores
• Need home building experience and skills
• No licensed contractor oversight creates risks

Owner-builder loans enable do-it-yourselfers to take on construction while financing the project. These loans require demonstrated building knowledge and skills.

Non-Conforming and Alternative Loans

Borrowers who don’t qualify for traditional financing have other options like non-conforming and alternative construction loans. These typically have higher rates and fees to offset the increased risk.

Types include:

• Fixer upper loans – Finance construction along with purchase of rundown properties requiring renovation
• Low doc loans – Alternative for self-employed or others with limited income documentation
• Low/no down payment loans – Loans requiring little or no down payment, usually with mortgage insurance
• Bank statement loans – Use bank statements rather than tax returns for income verification
• Hard money loans – Asset-based lending from private investors at higher rates

Benefits:

• Loan options for those unable to get traditional financing
• Opportunity to build with less cash or lower credit scores

Drawbacks:

• Significantly higher rates and fees than conventional loans
• Higher criteria for borrower skills and financial strength

While pricier and stricter in their requirements, alternative construction loans open doors for a wider range of borrowers.

Choosing the Right Building Loan

With an array of loan options available, it is important to weigh your specific needs and financial situation when choosing a construction loan. Key factors to consider include:

• Budget – Make sure loan amount, fees, and interest costs fit your budget
• Payments – Compare payment plans and interest rates across loans
• Qualifications – Realistically assess if you can meet loan requirements
• Timeline – Ensure term is long enough to complete construction
• Flexibility – Determine if you want leeway in financing down the road

Shopping multiple lenders is wise to compare rates and find the best loan product for your construction project. A loan officer familiar with building loans can guide you through the pros and cons of each option.

Thorough planning and research are vital in securing construction financing. Following this guide will help demystify the wide array of building loans available and set your building project up for success.