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Home Buying

10/26/2022

How Do New Construction Loans Work?

We love seeing you working toward your goals, especially when you've got your sights set on the house of your dreams. You know the one. The pool and the big yard, the spa-like master bath and large kitchen - whatever it is to you. Whether you're building from scratch or majorly renovating your current home, a new construction loan can provide the financing you need.

What are new construction loans?

New construction loans are short term loans that cover the costs of rehabilitating or building a home, including the purchase of real estate, materials, labor, and permits. Since they’re only for construction, the terms are typically for 12 to 18 months.¹ During that time, your interest rate is usually locked, however, if construction isn’t finished at that time, you’ll need to extend the financing and your rate could change to whatever the current rates are.

Unlike a mortgage, which gets paid out in a lump sum, a home construction loan is paid out in phases to the contractor building your home. As each phase is completed, the lender will give the contractor the money they need for the next construction phase and your payments will typically only be for interest on the amount that has been taken out. The timeline for each phase and the amount given out for each one will be summed up in a draw schedule, created by the lender.

When you have a complete home, the remaining balance can either be paid off, if you have the cash, or transferred into a mortgage. How this happens will depend on the type of construction loan you get.

Here are the two main types of construction loans:

Construction to permanent loan: If you have a construction to permanent loan, your construction loan will automatically turn into a mortgage when construction is finished. It’s basically two loans in one - a construction loan and a mortgage. Also known as a single-close loan, this type of construction loan allows you the convenience of closing one time and locking in your rate on the mortgage during construction. The construction loan itself may still have a variable rate if construction goes on for longer than 12 to 18 months.

What’s great about this type of construction loan is that it’s less of a hassle. You already have the construction financing and the long term financing for when the house is done. Not only that, but closing one time means you don’t have to make two down-payments, and the fixed interest rate on the mortgage gives you a predictable payment down the road.

Construction-only loan: Construction-only loans are for the building phase only. They do not convert to a longer term loan, and will need to be paid in full when the house is finished. If you’ve recently sold your previous home, you may be able to pay it off right away. If not, you will need to get a mortgage, which will pay off the construction loan and give you long term financing for your new home.

Lenders will require a lower down payment on this type of construction loan, making it more affordable right away. This works well if you are living in your current home and won’t have extra cash for down payments until you sell. This option also gives you time to consider permanent financing from different mortgage lenders while construction is happening.

The downside to construction-only loans is that you risk interest rates going up before you close on a mortgage, which could lead to a higher monthly payment than expected.²

Other types of construction loans

Renovation loan: If you are only looking to renovate an existing home, a renovation loan allows you to wrap the construction costs into your mortgage. Most commonly, this is used when purchasing a fixer-upper and you need to get a mortgage and a loan to cover renovations at the same time.

Owner Builder loans: If you want to build your own home, you can always go with an owner builder loan and be your own general contractor. In order to do this, you’ll need to show experience in building homes or have a contractors license. Going this route means you will be the one receiving the funds from the loan, instead of a third party contractor.

New construction loan requirements

Finding a local lender that can guide you through the process will be helpful. They may already have experience working with the contractor you’ve chosen and understand the cost of building in your market, which could make the entire process a lot smoother.

Once you’ve found the right lender they will take a look at these things for approval:

  • Your credit score - you will need good to excellent credit to get a construction loan. FICO lists good credit between 670-739 with very good to excellent credit going from 740 to 850. Never looked at your credit score? You can learn how to check and improve your credit score here.
  • Debt to income ratio (DTI) - This ratio shows how much of your monthly income is taken up by debt payments, and it gives an idea of how much more you can handle. Most lenders want this number to be below 45%. To find your DTI ratio, divide the sum of all your monthly debt payments by your monthly income.
  • Down payment - Most commercial lenders will require a downpayment of somewhere around 20% to 30% of the loan. Some government programs that require less, such as the FHA 203(k) which allows a 3.5% down payment.³
  • Project Budget - Lenders will need to see the budget for the entire project and approve it before approving a loan.
  • Your Contractor - Getting the right contractor is a big deal when building a new house. They will be responsible for keeping things on track and making sure the home is being built correctly. They also will be the one receiving the funds from your lender. Since they are a huge part of the process, your lender will need to approve the contractor you’ve chosen for the project, as well as the plans they have for the build.

Why construction loans are the best option for building a new home

Most people turn to construction loans for building or rehabbing their home because they allow you to pay only on the interest of the loan during construction, and live in your current house while your new home is being built. Overall it’s the most affordable option for most people and it keeps you from having to pay up front for everything.

If you are looking for alternatives, you do have some other options:

  • Hard Money Loan - The major disadvantage with these is that they come with higher interest rates and short loan terms, making them less affordable monthly. If you need to get started quickly on something, a hard money loan could help since they typically offer fast approval.
  • Personal Loan - These can be used for any purpose, but taking one out to build a new house would require a pretty large loan. With personal loans being unsecured, it may be hard to get one big enough to cover all the construction costs. These normally come with higher interest rates,making them more expensive. Since you will be paying on interest and principal, the monthly payments may also be more right away.
  • Home Equity Loan - If you're looking to renovate, this could be a good option if you have a good amount of equity in your home. Using a Home Equity Line of Credit (HELOC) would allow you to draw money out as you need it and pay the loan off after the draw period.

    On the other hand, a home equity loan or line of credit may not be the best option when building a new home. It requires refinancing your current home, so if you already have a good mortgage rate and rates have gone up since, it may not be cost-effective. You also would need a significant amount of equity in your current home to be able to build a new one using a home equity loan or HELOC.
  • Credit Card - You wouldn’t be able to use a credit card to finance the building of a new home, but you could use one to finance the remodeling of your home, or at least part of it. The downside here is pretty big, which is that credit cards almost always have high adjustable interest rates, and you will end up paying a lot more if you can’t pay it off quickly. The only reason to go this route is if the changes are more of an urgent need than a desire - meaning you could use this to repair or replace a broken HVAC system in the middle of summer, but maybe not to install a pool in the backyard.

Get Started with Southern Bank

If you’re ready to get started on that new house, or if you’ve got some great ideas of how to remodel your current home, we have lenders ready to help you get the financing you need. Our local lenders know the market for construction in your area, and they are experienced in helping you finance the house of your dreams. To find a Southern Bank lender, you can visit our Find a Lender page and search for one nearby. You can also call us at (855) 452-7272 to get started.

Found your dream home? Make it yours with a mortgage from Southern Bank.

Disclosures & References:

1 Kiah Treece, Rachel Witkowski, Construction Loans: What They Are and How They Work, forbes.com, Apr 8, 2022,
https://www.forbes.com/advisor...

2 How Home Construction Loans Work and How to Get One, americanfinancing.net, Accessed Aug. 15, 2022,
https://www.americanfinancing.net/...

3 Linda Bell, Hal M. Bundrick, How Construction Loans Help Finance Your Dream House, nerdwallet.com, Mar 29, 2021,
https://www.nerdwallet.com/...