Build a Home with a Construction Loan in 5 Steps.
Construction loans are very useful, however, not every lender or loan officer can help you with these requests.
Considering constructing your dream home from scratch? The construction loan process might appear daunting, but today, I’ll simplify it into 5 straightforward steps, so you’ll know what to anticipate and how to proceed confidently.
Step 1: Find a Construction Lender and Get a Lending Commitment
To begin with, there's never just one method to accomplish something. However, if you're new to building a home and your project depends on a construction loan, it's essential to find a lending partner first. Secure this aspect before consulting builders, architects, or designers. Understanding your borrowing capacity and the type of construction loan that suits you is crucial.
Understand that not all lenders provide construction loans. Many banks or mortgage brokers are unable to offer these loans because they either lack the product or choose not to offer it. Construction loans require more time than most loan officers can allocate and are too complex for most lenders to handle.
A construction loan is generally a hybrid loan, consisting of a single loan divided into two phases: a temporary loan that transitions into permanent financing. Within this structure, there are various nuances regarding when borrowing actually starts. The first phase, the temporary portion, is divided into stages. For instance, the first disbursement might occur after the foundation is completed, the second after the framing, the third following the installation of mechanicals, then the exterior and interior, followed by the trim, and so forth. It's crucial to understand that the bank will not provide all the funds upfront; they will release the loan funds based on the work completed or materials installed. This highlights the importance of having a draw schedule, along with a budget and cost breakdown.
Leverage a single close construction loan to simplify your project. While construction loans don't have to be a single loan, they can follow a similar format but may require two closings: one for the temporary loan and another for the permanent loan. This setup can sometimes have benefits, but consider that you are qualifying for two loans that could be separated from a year or more apart. Two loans means double the paperwork, double the closing costs, double the appraisal evaluations, and double the hassle. Although this might work in some situations, for most people, it is inconvenient.
As the funds are distributed gradually, the loan balance grows throughout the construction period. Consequently, anticipate interest-only payments during the temporary stage, as the balance will rise the following month, resulting in a higher bill. Regardless of the term you choose, the payments exclude any principal. Principal payments are postponed until the permanent stage.
If this all makes sense, once the temporary phase ends, the loan functions like a standard mortgage where you repay the debt. Aim for a credit score of 680 or higher to qualify for maximum financing and secure the lowest rates. Construction loans are considered riskier, so anticipate higher market rates compared to a traditional mortgage.
Similarly, lenders prefer to see a 2-year history of income and the capability to document it. Additionally, since your dream home won't be finished for another year, you'll need a temporary place to live. If this involves a mortgage, you might have to qualify for two homes simultaneously, which can be challenging at this point.
Similar to any other loan, having sufficient reserves can assist you in finalizing the deal or staying adaptable in the event of cost overruns during the construction, which is a frequent occurrence.
Step 2: Finalize Plans & Pick Your Builder
Next, following the approach of contacting the lender first, you will need a set of plans and specifications. Some companies provide a design and build service, acting as a one-stop shop where you can complete all your architecture, design, and engineering needs in the same place as the construction. Some builders may not offer specialty services but are happy to provide recommendations, including for a lender. Before you can finalize your loan, there will be a builder's checklist that includes all the design elements of the project and a description of the materials you will use. Your lender is not funding a dream—they're funding a detailed project.
In addition to the budget, the lender will need a detailed cost breakdown that lists all project expenses item by item. Allowances are acceptable, but lenders prefer not to have estimates for any part of the construction. They want to ensure that the figures in your cost breakdown align with those in the contract to determine the capital required for closing and the appraisal value of the home.
I've noticed many requests in the past year for "owner-builder" construction loans, which can be accommodated by some lenders. However, this is often not a viable option. Lenders prefer that you are licensed and experienced, and if you are applying as an owner-builder, they have additional income stipulations, deposit requirements, or consider it an exception to their credit policy.
Reputation is important in all things. Ask for past projects, references, and timeline adherence because your investment is at stake. The builder's reputation is crucial, including their relationship with suppliers, and ability to balance a number of contracts the same time.
Below is a list of essential builder documents you should have ready for your lender.
Fully Executed Contract, signed by builder and owner
Detailed Cost Breakdown for a total project cost that matches the contract
Copies of the complete plans & specifications
Description of materials
Copies of invoices and proof of payment for any soft-costs
Step 3: Close the Loan
After receiving all necessary builder needs, you can submit them to your lender for approval and proceed with the appraisal. Depending on the amount of your loan request, the lender might require one or two appraisals. The value of the construction is determined by comparing it to similar homes in the current market, not based on future value.
The appraiser must evaluate your home by comparing its design and materials to similar homes that have recently sold and closed. The appraisal should include several comparable homes to determine the market value. Expect to see at least one with larger square footage, and one with smaller square footage and home of higher and lower value. This method of comparable selection is known in the industry as bracketing. Similar to traditional mortgages, lenders will base their loan on the lower amount between the construction costs and the appraised value. However, this can vary depending on the equity you have in the land and when you purchased the property.
The loan closing feels like any other mortgage loan, except that you might already own the property. At signing, your builder might request a draw if they haven't received a deposit or if they need an advance for custom materials or to prepay for specific window packages.
If you have a draw at closing, it means you will make your first interest-only payment a month later. If there is no draw, you might not have a payment until the first inspection is completed after the funding of the initial draw.
Step 4: Build the Home & Draw Process
Construction begins — but the money isn’t handed over all at once. It’s released in draws that are progress based.
Funding is organized according to stages, such as the foundation, framing, mechanicals, drywall, exterior, then the cabinets and finishes. Usually, the lender does not conduct the inspections; these can be carried out by the title company or the appraiser. Before the builder receives funds, the property must pass inspection. Lien waivers are collected, the title is updated, the builder is paid, and this process is repeated with each stage.
Sounds simple, so why are they deemed high risk? One major reason is the cost of building a home. Since the pandemic, most builders have opted to work on a cost-plus basis, meaning the builder charges the actual cost plus a margin. This means that if costs rise, your budget will increase, potentially requiring additional capital from you, not the lender. If you lack the funds, the project might stall. It's common for change orders to be requested during the process, which can increase costs or force you to reduce another part of your budget. During the pandemic, extensive material backorders and significant cost increases resulted in many homes not being completed on time, which added to or increased costs, compelling owners to make difficult decisions.
As with any business arrangement, effective communication between the lender, builder, and title company is essential. While lenders and builders have more specialized roles, title companies are indispensable partners due to their expertise. They are managing the project every step of the way, relaying updates from the builder to the lender, coordinating the payments, and keeping clean title. They ensure the project progresses smoothly and help prevent delays. Do not overlook the importance of these duties to your project.
Step 5: Convert to a Permanent Mortgage
Finally, all the dust settled, it's time to move in and turn that temporary loan over to your forever mortgage.
If your lender provides a single close construction option, it is ideal because it requires no additional action. Your loan will seamlessly transition from interest-only to principal and interest payments. In this scenario, there is no need to requalify or appraise the property because the draws are completed. The original note is modified and recorded with the county. However, if you have a two-time close, you will need to refinance the remaining balance of the temporary loan into a permanent loan. This step carries significant risk, as interest rates may have risen since the temporary loan began. Home values should be equal, or higher, but a lot of change can happen in a year.
If the completion and delivery of the home is delayed or postponed, that will make scheduling the second loan more challenging. This adds to the complexity of the double close. Securing a rate with either the same or a new lender can be difficult. Or if the updated appraisal results in a lower value than at the beginning, you might need additional funds. If there were cost overruns that demanded more money than initially planned, this situation could become problematic.
Lastly, another reason I favor the single close is that the ending balance is converted for principal and interest payments. If you included a contingency in the budget and didn't need the extra funds, or if you stayed under budget, the final balance would convert to the permanent loan amount. Likewise, the principal and interest payment will adjust to the final loan amount. Similarly, if you self-funded the last draw or sold your home and have capital to roll over, you can reduce the balance of the permanent loan during the conversion phase.
Building your dream home doesn’t have to be intimidating — especially if you break it into steps. If you’re thinking about building or have questions about getting started, let’s talk!