A Giant Home Credit Card – How Do Home Construction Loans Work?

By Frank Coutinho | Aug 21, 2018
Photo by: Pexels

Wouldn’t it be great if you could finance a home from vacant land to dream home with a credit card? Building a home involves many deadlines; blueprints, building materials, contractors, and tradesmen all need to be paid upon delivery or completion. For even a small project, this can mean thousands of dollars over the course of the project. If your last name isn’t Rockefeller, then you might think that a custom home is out of reach, but a home construction loan actually acts like a giant credit card to help you make these payments along the way and build your dream home.

 

What Is a Home Construction Loan?

 

You may not know how construction loans work, but they are actually fairly simple. A home construction loan varies from the traditional home mortgage in several ways. If you think about it as a line of credit (or credit card), where you incur charges as needed, it will make more sense. As you move through the construction process, you will draw on the loan amount to pay for builders and supplies as needed. You only pay interest on the amount borrowed and these are usually interest-only payments.


As an example, if you have a home construction loan for $500,000 and need to pay $25,000 for building materials at the start of the project, you will only pay interest for the $25,000 until you spend more of the loan amount. Just like a Giant Home Credit Card, when you borrow, you make payments. The entire amount used is then paid off when you complete the project and move the loan to a permanent mortgage.

 

You Need Both A Home Construction Loan and a Permanent Mortgage

 

The home construction loan only lasts for the duration of the construction itself. Once the project is completed and inspected, then you will need a permanent mortgage. There are two types of lending products available for this: standalone construction loans and construction to permanent loans.

 

Construction to Permanent Loans

With this type of financing, you will use the same lending instrument for both the construction and final mortgage. You will apply for both at the same time and the all the paperwork is done up front. One of the biggest advantages of the one-step construction loan is that you know the costs and final interest rate before you begin the project, taking the guesswork out of financing. It’s important to carefully consider all aspects of the project however; delays and changes must be factored into the loan because if the project goes outside your loan limit, you will need to pay out-of-pocket for the difference.


Two-Step Construction Loans

A two-step construction loan, by comparison, is one where you will find your final mortgage after the construction is completed. The two-step construction loan allows for changes and increased costs during the construction phase, within reason. Because you do not need to have the permanent mortgage amount set before beginning the building project, you have more flexibility to adjust for delays or changes.

 

Qualifications and Down Payments

As with all home loans, the lender will use similar criteria when qualifying the potential borrower. Credit scores, work history and ability to pay will all factor into the qualifying process. The amount you can borrow will vary by loan program but is generally less than a home loan for home that is already built. The lender is loaning based on future value vs current value, so the risk is greater and if the borrower does not complete the project at all, they want to have some compensation to allow them to complete the home.


Maybe you can’t finance your new construction home with your personal credit card, but a home construction loans can help you do the same thing. By paying interest only on the actual money you use from your loan limit, home construction loans allow you to borrow as you go for plans, labor and materials needed to create your dream home from scratch.

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