The Basics of Construction Loans: Buy Land and Build New
When it comes to buying land for the sole purpose of building a brand new home, it’s important to understand the basics of construction loans before you start the process. Construction loans are offered by most banks and other lenders, but there are some important differences to note from personal loans or mortgages.
In this article, we’ll discuss the basics of construction loans, including loan parameters, eligibility requirements and how construction loans work when buying land and building a new home.
What is a Construction Loan?
A construction loan (sometimes called a home improvement loan) is a short-term loan used to fund the building of a permanent structure on a piece of land owned by the borrower. These loans typically last between four and eighteen months and are most commonly backed by the Federal Housing Administration, although other government-backed loan programs may be acceptable.
Unlike traditional mortgages or home equity loans, the funds from construction loans are released in a series of payments known as draws. Each draw is released as the construction progress reaches predetermined milestones, such as groundbreaking, framing, and drywall installation, rather than releasing the entire loan amount all at once.
Eligibility Requirements
Eligibility requirements for construction loans will vary from lender to lender, but generally, lenders who finance construction loans require borrowers to have:
- A credit score of 640 or higher
- A maximum loan-to-value (LTV) ratio of 80–90%, which is based on the total cost of the land and construction
- A debt-to-income (DTI) ratio of 50% or less
- Proof of income and employment verification
- Down payment of 10–20%, depending on the lender
In addition, borrowers may need to provide an appraisal of the property, an estimate of building costs and a budget for any other expenses, such as site preparation or permits, suitable for the lender’s criteria.
How Construction Loans Work
The structure of a construction loan depends on whether it is a one-time close or two-time close loan.
One-Time Close
One-time close loans, sometimes referred to as all-in-one loans, are when the borrower applies and closes on the loan at the same time, and the loan is used to fund both the land purchase and the construction of the new home. This can be helpful when it comes to interest rates, since the loan is structured based on the full costs of the project, rather than costs for the land and for construction.
Two-Time Close
A two-time close construction loan is when the initial loan is used to fund the land purchase and an additional loan is taken out to complete the construction of the home. This type of loan is usually preferred when there is a significant difference between the cost of the land and the cost of the new home.
With a two-time close loan, the borrower must apply for and close on two separate loans, with each loan at its own interest rate, and will typically have to pay closing costs and fees twice.
Construction Loan Terms
When you take out a construction loan, you can expect the terms of the loan to include:
- A term of four to 18 months
- An adjustable-rate or fixed-rate interest rate
- A down payment of 10–20%, depending on the lender
- A loan-to-value (LTV) ratio of up to 80–90%, depending on the lender
- Interest-only payments during the construction period, billed on a monthly basis
- A balloon payment due at the end of the loan term, which is the balance of the loan amount
- Closing costs and fees
How to Find the Right Construction Loan for You
When it comes to finding the right construction loan for your needs, it’s important to shop around and compare loan terms from different lenders. Talk to several banks and credit unions to compare interest rates, fees and other loan terms in order to find the loan that offers the best overall value.
It’s also advisable to speak with a financial adviser or specialist to make sure you understand all the details of the loan, as well as any potential risks or drawbacks. A financial adviser can also help you develop a plan to make sure you can meet the payments and other obligations of the loan.
The basics of construction loans should be at the top of your mind when it comes to buying land and building a new home. Construction loans typically have different terms than traditional mortgages or home equity loans and can have significantly different eligibility requirements. It’s important to compare different loan offers from various lenders and speak to a financial adviser to make sure that you understand your payments and budget for the loan before you decide to take it out.
