How home construction loans work

Finding your dream home can be challenging. This is especially the case when existing home inventories are tight and the new neighborhoods under development just don't hit the mark for you.

If you find an ideal piece of land, however, you may consider building your own residence from scratch. It's a much different process from buying a finished home, but it offers the ultimate control over incorporating your own tastes and touches into the place you'll live.

Of course, financing a new construction or major renovation project is also very different from taking out a traditional mortgage on a market-ready home. To get a sense of what to expect, we asked Erik Taylor, Senior Vice President and Mortgage Banker at First Citizens, to help clarify some of the key points about construction loans that make them different—and can make them more useful—than a typical home mortgage.

What are home construction loans?

As the name suggests, a home construction loan is a loan that's used to build a new home or renovate an existing one. Construction loans can be used to cover contractor costs, construction permits, building materials, the cost of the land and more. Construction loans typically have additional guidelines and requirements compared to conventional loans.

How do home construction loans work?

Home construction loans are similar to conventional mortgages, with a few key differences. As with other home loans, you'll need to have qualifying income ratios and credit scores to obtain financing. But home construction loans take a little longer from beginning to end, as there are more people and details involved in the process.

For example, details that can make the process of construction loans take longer include the development of building plans and specifications, building contracts, and budgets. Construction loans also may include a contingency reserve to cover unexpected costs often associated with the building process, such as weather delays or supply shortages. The reserve can also serve as a cushion if you decide to make upgrades after construction begins.

What types of construction loans are available?

Construction loans can be shaped in several ways. The primary type residential homebuyers may choose from include construction-only loans, construction-to-permanent loans, renovation loans and owner-builder construction loans.

• Construction-only loans: These cover only the cost of construction. They may have higher interest rates than a conventional mortgage and the typical duration of the loan is 1 year, during which time the construction must be completed. After construction, you'll have to refinance your construction loan with a new mortgage loan.
• Construction-to-permanent loans: Unlike construction-only loans, all financing is rolled into one loan. There's no need to get another loan when construction is done, making the process simpler for you.
• Renovation loans: These are used to renovate a home to your needs. The value of the loan is based on the estimated value of the home when the work is done, so if you plan to put enough upgrades into a $100,000 home to add $200,000 to its value, your loan could be based on the final estimated $300,000 value.
• Owner-builder construction loans: These may be worth considering if you want to serve as your own contractor to build your personal residence, but they're not an option for everyone. At a minimum, the bank will need to know that you're qualified to successfully manage the complexities of building a house, so you may need to have a general contractor's license. And while other extensive construction industry backgrounds may be considered in some locations, the bank may not offer owner-builder loans in your state. If this is something you're contemplating, you'll want to talk to a banker to further explore your situation.

How do periodic draws help pay for the work?

Unlike a mortgage, in which you borrow against the value of the home you're buying, a construction loan—once you're approved—makes periodic payments, also referred to as draws, toward the build itself.

As part of the loan approval, you'll agree to a schedule of payments against the loan amount, which is referred to as a draw schedule. Draws are paid to the builder—who is typically the project's general contractor—as different portions of the project are completed and validated through inspection.

For example, payments may be made upon completion or installation of the following:

• Site preparation and house foundation
• Structural framing
• Drywall
• Plumbing and electrical systems
• Heating, ventilation and air conditioning systems
• Interior trim and flooring
• Connections to water, sewer and electrical services
• Final touches

Alternatively, the draw schedule may allow for a specific percentage of the total loan to be forwarded to the builder as certain completion thresholds are passed. General contractors may prefer this approach if your design requires an above-average amount of framing because lumber is typically the most expensive part of building a home.

How can you prepare for the loan approval process?

Understanding what's required to get your construction loan approved and preparing in advance for this process can help smooth the transition to approval.

Like a standard home mortgage, a home construction loan requires proof of your ability to repay what you borrow. Your lender will ask to review the blueprints for the residence and will validate that your builder's license is up to date. At the end of the day, your lender needs assurance that the builder can satisfactorily complete a major project that will result in a mortgageable property. As an added layer of security, you should always ensure your builder has a strong reputation, carries adequate liability insurance and is in good standing financially and with local housing authorities.

In some cases, the required down payment will be higher than what's required for conventional mortgages. However, select home construction projects may qualify for government loan programs offered through the Federal Housing Administration, US Department of Veterans Affairs and US Department of Agriculture.

Whether you want to start from the ground up and build a custom home or turn an existing house into your dream home, construction and renovation loans can be right for you. However, these special loans aren't for everyone. If you're considering a new home construction or renovation, speak with a mortgage banker first to fully understand your options.