The Basics of Construction Loans

Purchasing a home is an important decision that just about everyone faces at least once in life. Whether you choose to buy a fixer upper or build your dream home, a construction loan could be exactly what you need. These loans allow current and future homeowners to buy materials, pay for labor, or even purchase land to build a home. You won’t receive a lump sum, as it is paid out through installments, but it is a viable way to get the home you want. There are a few options available to you depending on how you want to use the funds.

Construction-only Loan

For those who plan on paying off a loan with the sale of their previous home or have enough cash on hand, this loan is a good option. This is a short-term loan with adjustable rates used to finish construction on a home. Once the project is complete, the loan must be repaid in full or refinanced in a mortgage. This means you will apply twice and go through two closings. 

Owner-builder Loan

Payments are made to the owner instead of a third-party contractor. One qualification of this loan is to have a contractor’s license or to show experience as a homebuilder. Because of this requirement, this loan is best for those who want to act as their own contractor and who have experience building homes.

Renovation Loan

If you are planning to buy a fixer upper and doing extensive renovations, this is the loan for you! This is more like a traditional mortgage; it covers the cost of purchasing the home and the renovations. The amount of the loan is based on the expected value of the home after the work is done.

Construction-to-permanent Loan

Homeowners looking to lock in a specific fixed rate on their mortgage and save money on closing costs will want to research this option. This loan provides financing for building a home, but when the home is built, it changes to a fixed-rate mortgage. 

While construction loans are good options for those wanting to renovate or build, there are some caveats. Since the home is unfinished, it cannot secure a loan, making this type of financing riskier than others. The process for approval is difficult, with lenders looking for approved plans, budget, and contractors, sufficient income, at least 20% down, good to excellent credit, and a low debt-to-income ratio. These loans are still a good option if you are set on building your own home or fixing one up.

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