Construction loans are loans on a dream – your dream.
However, if you want to get one of these, you’ll have to flesh your dream out. You’ll need to be able to sell the idea of your new home to the lender before you’ll get your loan. In fact, these kinds of loans are called “story loans” because the lender has to know the story behind the planned construction before they’re going to loan you any money.
You’ll likely need some documentation to back up your story: this could include plans, a selected contractor and other details. You’ll also need your deed for the property on which the home is going to be built. These kinds of details will make your information for the lender as complete as possible.
There are some common features to construction loans:
They typically require interest only payments during construction
They become due upon completion of construction. (This means the home has a certificate of occupancy, given by the municipality.)
Your construction loan is usually some kind of variable-rate loan, either priced to fluctuate with prime (plus some percentage) or some other short-term interest rate. You’ll need to have a construction schedule that the lender agrees to as part of the contract, since your “draw” of money will normally happen based on stages of construction. Your interest payment will depend on how much you’ve taken to date.
Another factor in construction loans is how much money you are actually looking for from the lender. In most cases, a lender will not give you 100% of the monies needed. However, if you own the land on which you will be building, this is usually considered equity on the construction loan.
A construction loan can be set up to convert to a mortgage after you’ve received your certificate of occupancy. This can be a significant advantage, since you’ll only have one application to handle and one set of papers to sign on closing. However, you will need to have enough equity in the project in order to qualify for this type of loan.
Why do you convert a construction loan? Well, unlike a mortgage, the construction loan is only meant to be around for a relatively short time period – the period of construction. This means that your interest rate is not as big a factor (unless you are negotiating for your loan to convert to a mortgage.) If you take out a construction loan for 6 months, and you pay an extra percent on the loan, it will cost you an additional $250 over the 6-month period. However, if you end up paying percent more on your mortgage, it could mean hundreds or thousands over the life of that mortgage.
It may be worthwhile to pay a bit more interest on a construction loan, if you can get better mortgage terms later from the same lender, versus going to other lenders. As usual, shop around!