Understanding Home Construction Loans

If you choose to build your home, you’ll find that you have the option to purchase a custom home. This option is great for those who want more to fully personalize their home to meet their tastes and needs.

While there are a few aspects of the buying and building process for a custom home that is similar to buying and building a production home, particularly when it comes to financing. When you build a home, you will likely need a home construction loan.

What Is a Home Construction Loan?

A home construction loan is a short-term loan (in most cases, one year) that is taken out by a builder or a homeowner to build a home. Borrowers typically only pay interest on the loan during construction.

“Once the construction is complete, contractors are paid and a certificate of occupancy is obtained, the loan will typically roll over into a regular mortgage,” says Bill Golden, a Realtor with RE/MAX Metro Atlanta Cityside.

Golden adds that during construction, the lender will pay a draw at certain intervals of construction. The lender may even have someone visit the construction site to see how the project is progressing.

Obtaining a home construction loan is slightly more difficult than a regular loan because your lender is loaning you money for something that does not yet exist. The lender may require what’s needed for a regular home loan, in addition to details about the project. “The lender will need to see a detailed set of plans as well as a detailed construction timetable and budget,” Golden says.

In addition to the detailed plans and timetable, the lender may require the general contractor to be licensed, a home value estimate by a qualified appraiser and possibly a higher-than-typical down payment (20 percent or more is standard), says Janine Acquafredda, an associate broker with House-n-Key Realty in Brooklyn, N.Y.

How Do These Loans Differ From Typical Home Loans?

Typical home loans are longer, usually around 15 to 30 years at a fixed rate. Borrowers pay the principal, as well as interest, for the life of the loan.

“A standard home loan assumes that the builder/developer is paying to build the home and all you are doing is getting a mortgage on a fully built home,” Golden says.

What Happens When the Loan Ends?

You’ll need to obtain a new loan, called the end loan, to pay off the construction loan. Golden says that in some cases, lenders will go with “a construction-to-permanent (C2P) loan,” which coordinates the construction loan with the permanent mortgage.” Doing this means there’s only one closing and one set of closing costs.

Do You Need to Own Land to Obtain a Home Construction Loan?

No, but owning land can serve as collateral, making the qualification process easier, says Golden. And, in some cases, you can include the cost of the land in the construction loan.

Building a custom home is rewarding an exciting. By understanding home loans, you can choose the right financing option for you.