By 2030, the global population will reach 8.5 billion, with more than 60% of the population living in urban areas. As reported by the World Bank, the UN estimates that nearly 3 billion will need to construct new houses by then to cater to the rising population.
Home construction is costly, and lending institutions associate it with many risks. So, how will you fund the development? And what about the people yearning to own homes but they can’t afford it?
Do they have reliable loans that can support them? Home construction loans can facilitate the process of home ownership.
Discussed below is a detailed outlook of what home constructions loans are, where you can get them, and why they are useful.
What Is a Construction Loan?
It is a short term loan used to finance the building of a house. Borrowers must repay construction loans within a maximum of one year. Therefore, the lender pays in stages as the construction progresses.
Construction loans have a variable interest rate, and the rates tend to be higher than that of the permanent mortgages. For the lender to approve the loan, the borrower must provide the construction timetable, a realistic plan, and detailed information about the repayment method.
How Does Home Construction Work?
Unlike a permanent mortgage which is given out as a lump sum, a home construction loan is paid in installments. The lender gives out the loan in different stages until the contractor completes the building process. The total cost is then transferred to the builder once they complete the construction project.
The installments are known as “draws,” where each draw covers specific costs for a particular phase of the construction.
The bank performs a regular inspection after each draw to find out if the previous amount has accomplished the project within the set timeline. You can only get the next draw when you have satisfied the lender with your current progress.
What Are the Benefits of a Home Construction Loan?
Some of the benefits of a home construction loan include:
Interest Only During the Construction
The borrower does not pay the full loan amount until they have completed the entire project. Also, the bank doesn’t ask the borrower to pay the principal before completion of the construction.
Although you must provide your specific plan for the building, construction loans have more flexible terms as compared to the traditional loans.
The Scrutiny Provides Structure
The added scrutiny and supervision ensures that the project remains within its timeline and schedule.
What Are the Drawbacks of Home Construction Loans?
- Harder to qualify-construction loans have higher quality standards in terms of down payment and terms of credit. Typically, a lender requires a down payment of 20% and a credit score of 680.
- Higher interest rates- the variable interest rates of home construction loans is usually higher than that of traditional banks.
- Short term loans are risky- you must have a reliable source of income since you will pay the entire loan amount at the end of the project.
Finding a Home Construction Lender
Because of their risky nature, not all financial institutions or banks lend home constructions loans. Also, the few ones who give out the loans tend to have very high-interest rates to convert the risk.
So, when looking for a construction loan lender, carry out detailed research and make useful comparisons. Review the specific requirements of all the lenders and their loan terms and rates. If you don’t get a lender willing to help you, check credit unions or the smaller regional banks.
Qualifying for a Home Construction Loan
As earlier mentioned, it’s hard to qualify for a construction loan as compared to the traditional mortgages. Typically, you don’t have a completed house that the lender can use as collateral, and thus the lender presumes the loan to be risky.
Lenders use the following criteria to determine your ability to repay the loan after completing construction.
- Credit score- you must have a credit score of 680 and above to become a candidate for the loan.
- Down payment- most lenders require the builder to make a 20-30% down payment for the total cost of the entire project. However, the renovation loan may require a lower down payment.
- Debt to income ratio– the lender ensures that your total liabilities are not more than 5% of your income. You qualify for a bigger loan if you don’t have any other loans.
- Repayment- you must have a reliable source of income to help you finance the down payment and the total amount when you complete the project. Also, the size of the project should not be too huge when compared to your income.
Types of Construction Loans
There are many types of home construction loans, but these are the most common:
One Time Close Home Construction Loan
These loans wrap mortgage and construction costs up into a single package. The lender finances everything during the construction and then transfers the costs during the closure of the mortgage.
This type of loan is perfect for people with a clear construction plan and timeline.
Also known as the stand-alone construction loan, it covers the cost of the construction only. It is only given to borrowers with a considerable capital or who have other buildings which they can sell to cover the additional expenses related to the project. You will pay the loan in full after the construction.
Renovation Construction Loan
This is given to a borrower with an already established building which only needs renovation. You can fold the loan into a mortgage once the renovation process is through. Most people purchasing fixer-uppers get this type of loan.
Home construction loans are reliable, although it’s hard to secure them. Make sure that you thoroughly research the available possibilities before you choose a specific loan.
Have adequate savings before you apply for a home construction loan. If the unexpected happens, it can lead to extra costs which your lender cannot provide. Also, beware that your lender will carry out regular inspections on the construction site.
You must, therefore, work with good project managers and planners so that they don’t mess your project. Contact us for more information and advice.