How to Finance your Home Build in 2023

How does the process for construction loans work?

Now that you've found a lot and analyzed the feasibility of building on the lot, and determined your rough construction budget, it's time to look into new construction financing options. 

Step 1:

Start by prequalifying with a local bank. Local lenders are always best for new construction loans because they know the local market, and builders much better than national banks and can get you approved much more easily. They will help you understand how much of a loan you will qualify for.

  • Credit: Ideally as high as possible. Lenders will look for at least a 640 credit score.

  • Income: Get your debt to income ratio below 40%.

  • Down Payment: Decide how much cash you want to put down.

Step 2:

Once you have a pre-approval budget you can start your house design. The lender will require a full set of construction plans and a detailed quote and draw schedule from your general contractor before they can move into underwriting. 

Step 3:

Bring these documents to a bank for approval. The bank will make sure your general contractor is qualified and ensure that the proposed house design will meet underwriting standards.

Step 4:

The bank will work with your contractor to create a draw schedule that will regularly pay out disbursements to your general contractor as work milestones (typically 4-6) are completed.

Step 5:

You close on the loan and begin construction. During the construction phase you typically only have to pay the interest payments on the loan (no principle).

Step 6:

After construction completion; What happens will depend on the type of loan you chose:

  • Construction-to-Permanent Loans: This is a single-close loan that automatically converts from a construction loan into a traditional 15/30-yr loan once construction is completed. The benefit is that there's only one set of closing costs to pay.

  • Construction Only Loan: This kind of loan only covers the construction period. Once completed, you will either have to pay for the house in cash or obtain a traditional 15/30-yr loan. This is a riskier and more expensive option because you will have to pay two sets of closing fees and will risk losing your income and qualifying ability.

Construction Loan Financing Infographic

Construction Loan FAQs:

Can I get an Owner-Builder Loan?:

A loan where the owner acts as the general contractor. Most lenders will not underwrite these kinds of loans unless the owner has a history of successfully building houses.

If you really want to go this route in order to save some money, this can sometimes be achieved by finding a general contractor who will oversee the project for a smaller fee but not perform the work.

  • General contractors have existing sub-contractor relationships. It will be much harder to both identify and get high quality subs under contract.
  • General contractors have significant local regulatory knowledge and relationships. In certain jurisdictions, passing inspections will take much longer with an owner-builder.
What kind of Construction Loan is right for me?:

There are a number of different loan programs that your local bank can recommend, depending on your situation. First figure out how much you need to borrow because FHA and USDA loans have borrowing limits. Next evaluate how much you are planning on putting in as a down payment.

VA Construction Loans:
  • 0% down payment

  • Max loan size requirements (see here)

  • Limitations: Must meet military service, income and location requirements. (see here)

FHA Construction Loans:
  • 3.5% down payment

  • Max loan amounts vary by location (see here)

  • Limitations: Must meet income and credit requirements.

USDA Construction Loans:
  • 0% down payment

  • Max loan amounts vary by location (see here)

  • Limitations: Must meet income and location requirements. (see here)

Convention Construction Loans:
  • 20-25% down payment

  • No max loan value limit.

  • Limitations: Must meet income and credit requirements.

What's the Minimum Credit Score for a Construction Loan?:

This will vary by lender. A hard floor will be around a 600 credit score but many lenders have a minimum of about 640.

I already have land for my construction loan, can I use that equity?:

This is not a problem. Most lenders will allow you to utilize the value of the land as a down payment.

Construction Loan Interest Rates?:

These will vary depending on your credit and market conditions but here is a link to current new construction mortgage interest rates. Contact you lender for a firm interest rate quote.

How long is the duration of a construction loan?

Typically construction loans last 12 months, but some can be up to 24 months if needed.

What does a construction loan include?

A new construction loan can include everything; from land to permits to materials, appliances, landscaping and labor. It generally does not include architecture / home design fees or furnishings.

Does a construction loan limit what I can build?

Generally consumer grade construction loans are only designed for stick-built or pre-fabricated single family, detached residences.

Should I Buy Insurance During Construction Loan?:

Your lender will require insurance before construction begins. Do not make the mistake of starting construction first because it will be very hard to get someone to insure the house until it is fully complete. The construction phase can be a very risky time because homes are at a high risk of fire damage before gypsum/drywall is installed. Vandalism or material theft during construction can be a common problem as well.

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