Getting a Construction Loan vs. a Home Loan: Learn the Differences

Unless you plan to pay cash for your home construction project, you’ll need to get construction financing and a mortgage for the outstanding balance when it’s finished. While you may have qualified for a home loan before, getting a construction loan for your home construction project can be a little challenging.

While it is certainly possible to get a construction loan as an owner-builder, lenders may turn away from you at first, thinking you are not qualified to handle such an undertaking. Consequently, it is important to be highly prepared and capable and competent when presenting your case to the lender. For example, don’t say, “I’ve never done this before, but I’m willing to try.” Instead, be positive, prepared, and professional. Never lie, anticipate questions and concerns, and have answers ready.

There are several types of construction loans to choose from, but one of the most popular for homebuilders is a construction loan that converts to a permanent loan once the home is complete. Although there are no standard specifications for this type of loan, as a guide, most only require you to pay closing costs once. That saves some money and makes the process easier. You do not have to go through the qualification process twice. The downside is that it’s nearly impossible to lock in a permanent mortgage rate, since you won’t close on the loan for another six months to a year.

Regardless of the type of construction loan you choose, you will likely be required to pay monthly interest on the construction loan amount during the construction phase. The amount you owe each month will depend on the amount you have “withdrawn” from the loan, not the total amount you can borrow. If you are approved for a $100,000 construction loan but have only withdrawn $50,000, then your interest payment will be based on $50,000. Construction loans typically carry standard (unamortized) interest and one to two percent above the prime rate, or whatever you’ve negotiated with your lender.

Qualifying for construction goes beyond the credit score and income requirements for a standard home loan. Bankers or lenders will want to know how you plan to approach your project and whether you are capable of building a house yourself. A full presentation to the bank will be in order. The following is a summary of what you will need to apply for a construction loan:

  • all the same financial information you would provide to obtain a standard home loan (financial statements, income verification, credit report, etc.)
  • a set of your plans (you can order multiple copies)
  • detailed specifications (the materials and finishes you plan to use)
  • a cost estimate
  • an appraisal (ordered by the lending institution. The appraiser will use the plans, specifications, and lot value to determine the amount)
  • your lot information (if you own it, etc.)
  • contractor bids (not necessarily required, but might be if this is your first project)

You may also consider providing any other documentation you can think of that will help indicate your ability and readiness to complete your project. The bank essentially becomes a silent partner in your project and will see to it that the house is built correctly. Demonstrating your ability to handle the project is key here.

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