How do Home Construction Loans Work?

Building your forever home can be really scary for many reasons. Now that you have your land picked out and your house plans drawn up, you are now ready to get a home construction loan.

A construction loan is unlike every other consumer loan out there, because what you are putting up as collateral isn’t even completed yet. You need to understand how home construction loans work before stepping foot in a bank.

how do home construction loans work

Where should you start?

Most banks want you to have equity, or cash, into the project. This is the down payment. The classic down payment is 20%, but that has since changed. I would advise someone to have at least 10% of the value of the completed property to put down. This does not necessarily have to be money, but that doesn’t hurt the bank’s approval process. A common down payment for home construction loans is the land it is going to be constructed on, if it is owned debt free. If you believe the appraised value will be $300,000, I would suggest you be willing and able to place $30,000 into the home’s construction. This will give you a 90% loan to value.

Lenders also want to see the borrower pay a portion of the total cost of the home construction. If you paid $20,000 (paid with cash) for the lot and the home will cost $180,000 to construct, then total cost of the project is $200,000. In this scenario, the borrowers have already spent $20,000 on the lot, or 10% of the total cost of $200,000.


How Do Home Construction Loans Work?

Construction loans for primary residents are closed in lines of credit. Most banks divide the amount into 5 draws as the home is being completed. For instance, when you complete your slab, the bank will give you a check for 20% of the total value of the loan. You start paying interest on the money you have drawn, which is why you only want to get the amount you need at the time. Every time a draw is made on the closed in line of credit, a home inspector will go out to your property to make sure the construction process is moving along like it should.

Once you have completed all of your draws, the home should be complete. After completion, another inspector will tour the property to make sure it is now suitable for occupancy. After approval, your construction loan will be either placed on an amortizing loan within your local bank, or be taken out in the secondary market.

You need to have your home financed on a 20 or 30 year fixed rate in the secondary market. With a fixed rate, your payment will never go up. If you do not qualify in the secondary market, the bank will keep your home loan in house. The drawback to having your home loan kept in-house at your bank is that the rate will either be variable or only fixed for a short amount of time. This can cause your mortgage payment to increase with interest rates.


Requirements for a Home Loan

Before you start on your home loan, be sure your credit score is above 640. You will also need your debt to income ratio to be below 45%. This means if you earn $100,000 per year, your regular debt payments need to total less than $45,000 per year. Meeting these two requirements will help you qualify for a home construction loan as well as help you qualify for the secondary mortgage market.

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