Building your own house can be the fulfillment of a lifelong dream for many people – but it can also be a long and expensive process. Most people can’t afford to pay for the cost of home construction up front, and getting a mortgage is usually not an option. After all, you’re asking a bank or a mortgage lender to give you money for something that doesn’t even exist yet.
That’s where construction loans come in. These types of loans can be a little more confusing than traditional mortgages and warrant some additional explanation. Let’s take a look!
A traditional home loan is a mortgage on an existing home that typically lasts for 30 years where the borrower makes principal and interest payments for the life of the loan – either at an adjustable or fixed interest rate.
A construction loan, on the other hand, is underwritten to only last for the length of time it takes to build the home – which is usually right around 12 months. With this type of loan, you are essentially receiving a line of credit from your lender and submit requests for money on which you pay interest as you go.
There are two main types of home construction loans.
With these loans, the lender advances the money to pay for construction. Funds are released based on your contactor’s requests. For example, let’s say you receive a $300,000 construction loan from your bank. As construction begins, your builder needs money to get started and submits what’s called a “draw request”– perhaps $25,000. You would then only pay interest on the $25,000 advanced as a result of that request, rather than the full $300,000.
Once the home is completed and has passed the lender’s inspection, the permanent loan takes over. The loan is automatically rolled over – you do not have to attend another closing and/or pay more fees. You are now in the permanent portion of this loan, which means you are paying different terms. The interest rate that you pay on the permanent loan is the one that was locked in when you initiated the process and closed on the construction/permanent loan.
2. Stand-alone construction:
A stand-alone construction loan is solely for the construction phase. At this point, you are only applying for the construction portion of the process – you do not have permanent financing. This means that you have funds to have the home built, but you do not the financing to live in the home for the remainder of the term.
For example, you built a $300,000 home. At the completion of construction, that $300,000 will be due to the lender. Since you likely don’t have that amount of money at hand, you will need permanent financing. Since you obtained a stand-alone loan, you will have to apply for the permanent financing all over again. This means going through the approval process again as well as the closing process. It also means paying more fees as you have to do the entire mortgage process from beginning to end.
Qualifying for a construction loan
Many banks have relatively strict qualification guidelines for construction loans – that’s because the lender is giving you money for something that is not yet constructed, with the assumption that it will be worth a certain amount when it’s done. That requires some trust.
Common qualifications include:
- A qualified builder who is a licensed general contractor with an established reputation for building quality homes must be involved.
- Detailed specifications (including floor plans) must be available.
- The value of the home must be estimated by an appraiser.
- You need to put down a down payment, which can be around 20 percent at the minimum.
If you’re thinking about building your own home, stop by your local MidWestOne location to speak to a mortgage banker. They’ll be more than happy to get you off on the right foot!