Posted on 02/22/2022

Learning More About Construction Mortgage Loans

6 minute read

In today’s competitive housing market, it can be a challenge to find the right home for you. Sometimes even when you find the right home, you don’t land the winning bid to secure the purchase.

While the housing market is tight, so are building materials to start new homes. Despite this supply chain challenge, many are opting to have their dream home built instead of buying from the existing market.

What's in this article?

What is a Construction Loan?
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How Do Construction Loans Work?
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What’s Covered Under a Construction Loan?
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Types of Construction Loans
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Construction-Only Loan
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Construction-to-Permanent Loan
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Renovation Loan
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Owner-Builder Loan
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End Loan
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Steps to Seek a Construction Loan
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What You Need to Know About Construction Mortgage Loans
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However, to have a new home built, a construction mortgage loan must get approved. Are you wondering about the ins and outs of a home construction loan as opposed to acquiring a traditional mortgage?

While both are loans to borrow for buying a house, construction mortgage loans are quite different from traditional mortgage loans.

Let’s learn more about getting a construction loan for a new home build.

What is a Construction Loan?

So, how is a construction loan as opposed to a traditional mortgage for an existing home different? When you buy an existing house with a traditional mortgage, the loan amount is the cost of the house, plus possibly some closing costs included. This is a long-term loan for the pre-established amount of the existing as-is house.

A construction loan, however, covers more than just the house. It covers the costs associated with building and paying for a new house to be built. This might include not only building materials, but also paying contractors, purchasing land, and getting the needed inspections completed.

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How Do Construction Loans Work?

When you purchase an existing home, the home acts as collateral for the lender, but with a construction loan, there isn’t the same collateral available.

For this reason, often construction loan mortgage rates have variable interest rates, and often the rates are higher than a traditional mortgage because there’s more risk for the lender. Lenders will often expect more of a down payment with this type of loan as well.

The lender requires a construction timeline, detailed plans, contractor information, and a realistic budget spelled out before they will approve a construction loan.

The lender will expect the timetable spelled out in the agreement to be followed, along with sticking to the planned budget.

Once the home is completed and inspections are done, then the construction loan is either paid off or converted to a traditional mortgage.

What’s Covered Under a Construction Loan?

Construction loans are very specific about what they can cover. It can only include those things necessary to get a home built. This might include:

  • Purchasing land for the building site
  • Design costs
  • Architectural plans
  • Building permits
  • Materials for construction
  • Construction labor
  • Closing costs
  • Permits
  • Inspection costs

Typically, the construction loan will have built-in reserves if the project goes over budget and to cover interest costs during the life of the loan.

Types of Construction Loans

As you consider building a home, there are several different types of construction loans. Depending on your situation and needs, you can select the construction loan that’ll work best for you.

Let’s take a closer look at the different types of construction loans.

Construction-Only Loan

A construction-only loan covers the cost of the construction. The borrower would be responsible for paying off the balance of the loan upon completion of the new build.

The funds for this type of loan get distributed based on how much of the project is complete. The borrower pays the interest payments during the life of the loan.

Once construction is complete, the borrower would need a new mortgage to pay off the construction-only loan.

Construction-to-Permanent Loan

In a construction-to-permanent loan, the borrower has a construction loan while the home is being built. Once it’s complete, the lender will start converting a construction loan to a mortgage.

The nice feature of the construction-to-permanent loan for the borrower is that they only pay closing costs one time, instead of a construction loan and then again on a traditional mortgage.

Renovation Loan

If you already own a home, but are hoping to do major renovations, you might get a type of construction loan called a renovation loan.

There are many options available once you own a home, so you want to do your homework. You might refinance the home and include the renovation costs, get a home equity line of credit, or a home equity loan.

Owner-Builder Loan

This is a rarely used option for construction loans. In an owner-builder loan, the borrower also acts as the builder doing the work on the house.

Most lenders won’t approve this type of loan unless the borrower is also a licensed builder.

End Loan

The end loan is a lending term that refers to the loan the borrower has once the construction loan has been converted to a traditional mortgage.

The end loan is the loan you’d pay off over the long term, compared to the construction loan that’s paid on while the construction is in progress.

Steps to Seek a Construction Loan

Getting a construction loan will be similar to getting a regular mortgage in some ways. The lender will consider things like your down payment, credit score, and ability to afford the mortgage.

However, a construction loan is more complicated to secure. The lender will want you to secure a licensed builder, and you’ll need to provide documentation.

The lender will want to see references and credentials for the builder. They will also want copies of their license and business insurance. You’ll need to provide detailed pricing and plans for the home being built.

Like a traditional mortgage, you can seek a preapproval. This will help you to know what budget to plan for when making decisions about the new construction.

What You Need to Know About Construction Mortgage Loans

Building a new home can be an exciting prospect. You’ll need to make important decisions to be eligible for construction mortgage loans.

Use our construction loan mortgage calculator to help you see what you might qualify for if you hope to build a new home using a construction loan.

Contact us today if you’d like more information about how Compass Mortgage can help you with the construction process.

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