Just like buying an apartment or a house, building a home can be an alternative to owning your own home. It’s also a good option for those that want to customize their home from the ground up. But if you do not have funds on hand to build your dream house, you can consider applying for a construction mortgage. This loan can cover several costs, including buying the land, paying for the raw materials and the labour cost.
Construction mortgages can be different from traditional home loans in the manner of how funds are disbursed and the structure of the loan, and there are multiple types of construction mortgages to choose from. The application and verification approval process might be time-consuming and more complex than a regular loan.
So in today’s article, we will be walking you through the basics of a construction mortgage, the type of construction loans and how they work.
Defining a construction mortgage
In simple terms, a construction mortgage is a short-term home-loan program that most people use to cover the overall costs of building a house from the beginning until the end. You can convert it into a regular mortgage after a specific period, or it can be used as a construction-only loan.
Usually, these loans are available for less than one year, and the balance can be paid out during construction in monthly installments, which are also known as draws. After completing the one-year duration of the loan, a certificate of occupancy usually needs to be submitted to the money lender or the bank.
A construction mortgage covers everything, including the cost of the land, drafting the plans, paying for raw materials, paying for labour and taking out permits. The person can also use the construction mortgage to access contingency services if the project is far more expensive than planned.
How does a construction mortgage work?
Construction mortgages usually come with variable interest rates, which increase or decrease with the prime rate. The interest rates are typically higher compared to standard mortgage loan rates. Your property acts as collateral for a traditional mortgage or a home equity loan, and the moneylender can seize it if you fail to make the payments. On the other hand, the lender does not have that option open for a construction mortgage, so they charge higher interest as they consider these loans a significant risk.
Availability of funds
A construction mortgage is available for a short period and depends on the project’s completion. Therefore while applying for the construction loan, you have to share the construction timeline, project details and overall budget with the moneylender.
Once the construction mortgage is approved, you will not receive the entire fund as a lump sum amount. The borrower will draw a schedule which will follow the different construction stages of the project. During the construction stage, the borrower only has to pay the interest. The lender will pay out money in stages for the construction loan or mortgage as the work progresses.
These draws or stages of the project happen when significant milestones are reached. For example, when the foundation is laid, the brick and mortar work for the superstructure begins. The borrower only needs to pay the interest on the funds received until the last day of construction.
Inspections
While you are building your house, the moneylender might appoint an appraiser or a quality inspector to check your home during the different stages of construction. Once the inspector approves the project, the moneylender will disburse the additional payments known as draws. You can expect about 4 to 8 inspections during the construction period to monitor your progress. In many cases, the borrower does not need to start making payments until 6 to 24 months after the loan is disbursed.
The borrower can also convert the construction mortgage to a traditional one once the construction is complete. This process is known as a construction-to-permanent loan, and it depends on the moneylender and the type of loan you have applied for. If you do not have the option, you can always apply for a mortgage or an end loan to pay off the entire construction mortgage at once.
Construction mortgage rates
Like most other types of loans, the interest rate on a construction mortgage also depends on your credit score, payment history, loan duration, and loan size. Furthermore, the interest rate on construction mortgages is variable, so they can change over the course of the loan based on the prime rate.
The interest rate is about one percent higher than the standard mortgage rates. Construction mortgage rates will vary between 5 to 6% in most cases.
What are the requirements for a construction mortgage?
A construction mortgage is riskier for the moneylender as a completed home does not secure the loan. Therefore the approval process will be complicated. Here are some of the things that money lenders consider:
Low debt-to-income ratio
DTI is the comparison of all your monthly debt to your monthly income. So to apply for a construction mortgage, lenders usually require a DTI ratio no higher than 45%.
A good credit score
To reduce risk, most money lenders offer construction mortgages to borrowers with a minimum credit score of 680. However, many money lenders might not approve the loan unless you have a credit score of at least 720. So, if you are planning to construct your house, it is advised that you take a look at your credit score and improve it before applying for a mortgage or loan.
Note that some private lenders may ignore this criteria in exchange for other requirements, so it’s a good idea to ask around and find a lender that can work with you regarding this.
Good income history
Another critical point that will be considered is that you should have a strong credit history. In simple words, the moneylender will check whether you have enough income to cover all your payments, current debts and the new construction loan instalments. So you have to submit financial statements and your income slip to demonstrate your annual income.
Builder reputation
The moneylender will also check the builder’s background who will be constructing your house. So your architect or contractor has to be qualified, licensed and insured.
Endnote
Qualifying for a construction mortgage can be difficult compared to a regular mortgage. This is because you have to provide various financial information about yourself and the constructor or builder.
Additionally, for approval, you have to submit a signed construction contract along with a detailed project schedule, the budget of your project and the various phases of the construction project. Depending on your credit history and credit score, some money lenders might demand higher down payments or offer lesser time durations for the payback. It’s best to work with a lender that’s flexible and willing to set up a construction mortgage schedule that caters to your needs.
