How to Finance a New Construction

Finding a home that’s just right for you can be like looking for a needle in a haystack. The houses you visit might not be large enough, or they might be too big. They might not be located in a convenient area, or they might be in a place that’s too busy or noisy. The homes you view might not have the amenities you dream about or need to have in your residence.

If your house hunt is leaving you cold, you still have options. One option is to build your next home from the ground up instead of buying an existing house. Building a new home has many benefits. You can choose the style of the house, the number and type of rooms and the materials used.

Buying new construction is slightly different from buying an existing home in another way. The rules for loans and financing for new home construction aren’t exactly the same as they are for buying homes that already stand. Often, you’ll need to take out a construction loan first, which can convert to a mortgage once your home gets built. If you’re leaning toward building a new home, get all the details on the lending process.

Topics Covered

FAQs About Home Construction Loans
Single-Closing vs. Two-Closing Transactions
How to Finance New Construction: Types of Loans Available

FAQs About Home Construction Loans

Curious about the process of getting a construction loan? You likely have some questions. Let’s answer some of the most commonly asked questions about getting a home construction loan

1. How Do You Get Financing for a New Construction?

The process for getting a construction loan starts with an application. Most prospective home builders apply to several institutions to see what kinds of rates and loan terms are available to them. As you apply, you’ll provide detailed construction project information, including the contractor you’re working with, the building plans and timeline, and costs of materials and labor.

When approved for the loan, the borrower will place a down payment, or if they already own the land, they may be able to use the equity in their land as the down payment. The loan will finance the construction, and payment is due when the project is complete.

2. Is a Construction Loan a Mortgage?

Although a construction loan pays for the cost of building a home, it’s technically not a mortgage. A mortgage needs collateral, in this case, your home. When you are building a home, there isn’t anything to serve as collateral yet. Instead, a construction loan is a short-term loan that you either pay off once when the project is finished or convert into a mortgage.

3. What Does a Construction Loan Pay For?

Construction loans pay for most of the things involved in building a new home. The proceeds from the loan typically get paid to the contractor in installments or as certain building milestones are reached. The money can cover the cost of permits, materials and labor. The loan can also pay for the land purchased for the home.

4. What Type of Credit Score Do You Need?

Usually, borrowers need to have good credit with a score of at least 680 to qualify for a construction loan. The exact credit requirements can vary by lender and loan program. Some loan programs help people with lower credit scores purchase a new home and might be an option for you if your score is on the lower end.

5. How Much Can You Borrow?

How much you can borrow to build a new home depends on your income, the size of the down payment, and any other debts you have. Lenders may not let you borrow if your new construction loan puts your debt-to-income ratio above 45%. In other words, the amount you owe per month, including rent, credit card payments, and your new construction loan, should not be greater than 45% of what you earn each month.

6. What Are Interest Rates Like on Construction Loans?

The interest rate on a construction loan is likely to be slightly higher than the rate you’d pay on a standard mortgage. Once the loan converts to a typical mortgage, though, the rate might be more in line with what you’d pay to purchase an existing home.

7. What Percent Are You Asked to Put Down for a Construction Loan?

It depends on the construction loan you take out, but often, these loans require a higher down payment than other types of mortgages. If you apply for a conventional construction loan, you might be requested to put down between 20% and 30% upfront. With government-sponsored loans, a smaller down payment, such as 3.5%, is possible. Some construction loans have higher down payment requirements because lenders consider them higher-risk than standard mortgages.

8. Do All Lenders Offer Construction Loans?

Some lenders offer construction loans while others don’t. When looking for a loan, it’s a good idea to shop around. Luckily, Assurance Financial offers construction loans and can help you get started any time.

9. Is It Hard to Get a New Construction Loan?

In some cases, it can be harder to qualify for a construction loan than for a standard mortgage. But many loan programs make the process go smoothly and offer more accessible construction loans.

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10. Can I Build My Home Myself?

Many construction loan programs require you to work with a licensed and insured contractor and ask you to submit plans before your loan is approved. If you’re a professional contractor, you might be able to build your own home. Otherwise, expect to work with a pro.

Single-Closing vs. Two-Closing Transactions

Two categories of construction loans exist — construction-only loans and construction-to-permanent loans. Construction-only loans are also called two-closing loans, as you will go through the closing process a second time should you need a mortgage once your home is built. A construction-to-permanent loan is sometimes called a single-closing loan, as it automatically converts to a mortgage after construction is complete.

Single-Closing Loan

A single-closing transaction requires less paperwork and can be less expensive than a two-closing loan. You don’t go through the closing process twice, so you only pay one set of closing costs. While you initially might pay less out of pocket for a single-closing loan, the interest rate you pay might be higher than if you were to apply for a traditional mortgage. The interest rate is typically locked in at closing.

Single-closing transactions can have strict underwriting guidelines. Your lender is likely to calculate the loan-to-value (LTV) using the appraised value or the acquisition cost, whichever is less. The LTV is the value of your loan compared to the value of the property. Lenders use it to assess risk, determine interest rates and see if you need to pay private mortgage insurance (PMI).

During the building process, the lender will make payments to the contractor on a set schedule. As the home is built, the borrower can either make interest-only payments or decide to defer payments until the loan converts to a permanent mortgage.

Once construction finishes, the loan turns into a permanent mortgage automatically. The borrower begins making principal and interest payments based on the term of the loan.

Two-Closing Loan

Two-closing transactions are the most common. They have a more flexible structure and more flexible underwriting guidelines. The LTV is calculated using appraised value, and equity is considered towards down-payment.

Unlike a single-closing loan, when you decide to get a two-closing or construction-only loan, you’ll go through the loan application process twice. Doing so has its benefits and drawbacks. An advantage of getting a construction-only loan is that it gives you more leeway when it’s time to apply for a mortgage. You can shop around for the best rate and terms and aren’t locked into the rate offered on the construction loan.

A drawback of a two-closing loan is that you will go through closing twice. That means you’ll need to apply for a mortgage once your home is ready, and you’ll sign a whole new set of documents. You’ll also pay closing costs twice.

Since you have the opportunity to get a better interest rate on your mortgage with a two-closing loan, you may save money in the long run, even though you pay closing costs again.

Construction-only loans are due as soon as the project is complete. Usually, the term of the loan is short — about a year, if not less. If a borrower has trouble finding a mortgage to pay the remaining principal on the construction loan, they might find themselves with a big bill after their home is move-in ready.

How to Finance New Construction: Types of Loans Available

Just as you have choices when buying an existing home, you have mortgage options when looking into buying new construction. Several loan programs offer construction loans as well.

FHA Loans

The original goal of the Federal Housing Administration (FHA) loan program is to make homeownership affordable for as many people as possible. FHA loans make getting a mortgage more accessible in a few ways. They typically have lower down payment requirements than other types of mortgages. If you want to get an FHA construction loan, you can put down as little as 3.5%. Credit requirements are also looser with FHA Loans. You can have a credit score in the 500s and still be eligible for a mortgage.

FHA loans are guaranteed by the Federal Housing Administration but don’t come from the government itself. Instead, you apply for the mortgage through an approved lender. The lender reviews your credit, income, and other documentation before deciding whether to approve you for the loan and how much interest to charge.

The type of FHA loan you apply for depends on the type of construction project you’re undertaking. If you’re building a home from scratch, you’ll apply for a single-closing, construction-to-permanent FHA loan. At the start of the process, the lender dispenses funds to the builder to cover the cost of construction. When the home is complete, the loan converts to a traditional FHA mortgage.

The other option is for people who are renovating an existing home. An FHA 203(k) loan covers the cost of rehabilitating a fixer-upper or other house that needs some TLC. You can use an FHA 203(k) loan to renovate your current home or to purchase and renovate a new home.

Two forms of 203(k) loans exist — standard and limited. The standard 203(k) is for larger projects that cost more than $35,000. The limited loan covers projects with a price tag under $35,000. One thing to remember if you’re considering an FHA loan is that the loan will require you to pay a mortgage insurance premium. You’ll pay a premium upfront and for the duration of the loan term.

VA Loans

The Department of Veterans Affairs offers VA loans to help veterans and current service members purchase homes. Like FHA loans, VA mortgages come from private lenders and are guaranteed by a government agency, in this case, the Department of Veterans Affairs. Also similar to an FHA loan, a VA loan lets you purchase a home with a limited down payment. In the case of a VA loan, you might be able to buy a house with zero down.

VA construction loans have relatively strict requirements. In addition to being a current or former member of the armed services, you may need to meet several other requirements before you can qualify. Not all lenders that offer VA loans offer VA construction loans, so you might be required to dig around before finding an eligible lender.

When considering applying for a VA construction loan, the first thing to do is to find a licensed, insured builder. You may be required to work with a professional builder if you want to use the VA program to buy your new construction home. The program doesn’t allow owners to build their homes. Next, you and the builder will work together to create plans for the home. You’ll submit those plans to the lender when you apply. You’ll also submit documentation about the building materials and the lot.

For you to qualify for a zero-down payment on a VA construction loan, the home needs to be appraised. The design of the house can’t be too unique or unusual, nor can the house be larger or more luxurious than others in the area. A home that is too “out there” will have a lower appraisal value than a house that’s more standard. Getting a low appraisal can mean you can’t qualify for a zero-down payment.

After closing on the loan and building your new home, the property will need to pass an inspection by the VA. If it passes inspection, the loan converts to a permanent mortgage.

USDA Loans

USDA loans are also backed by a government agency, in this case, the United States Department of Agriculture. The loans are traditionally meant to help lower-income households purchase a home in a rural or suburban area. Like VA loans, the USDA loan program offers 100% financing in some circumstances, meaning a borrower can buy a home with zero down.

It’s possible to get a construction-to-permanent loan as part of the USDA loan program, although it’s worth noting that the list of lenders who offer USDA construction loans is more limited than the number of lenders who offer USDA loans. If you decide to apply for a construction-to-permanent USDA loan, there are several things to keep in mind. First, you need to meet income requirements. The maximum household income you can earn varies based on location and the size of your household.

Second, you need to build your home in an eligible area. The new house isn’t required to be in a completely under-developed area, but it can’t be in a metropolitan or urban location. Some suburban neighborhoods are eligible for USDA loans, as are most rural areas. As with a VA construction loan, you need to work with an approved builder if you’re going to apply for a USDA construction loan. You can’t build the home yourself.

Like an FHA loan, you’ll be required to pay mortgage insurance when you take out a USDA loan. The insurance remains in place for the life of the loan. You might also pay a slightly higher-than-average interest rate on a USDA loan than on other types of mortgages.

USDA construction loans are usually hard to find. While many lenders participate in the USDA’s loan program, only a few participate in the construction loan program. Depending on your home-building goals, you might be better off choosing a different type of construction loan.

Conventional Loans

Although government-guaranteed loan programs can help people build and buy their homes, they aren’t the right choice for everyone. You might not qualify for government-backed loans, or you might want to buy a home in an ineligible area. While some loans, like FHA loans, make it possible to buy a home with a lower down payment, their mortgage insurance requirements can be a turn-off for some buyers.

Fortunately, it might be easier to qualify for a conventional construction-to-permanent loan than you think. Although many people believe that you need a large down payment to get a traditional mortgage, especially when you’re building a home, there are programs available that will accept a down payment as low as 3%. The size of your down payment depends on the appraised value of the home.

If you do put down less than 20% on a construction-to-permanent loan, you can expect to pay private mortgage insurance. However, unlike the mortgage insurance attached to an FHA loan, you can stop paying the premiums as soon as your LTV reaches 80% When your LTV reaches 78%, the mortgage insurance premiums will automatically terminate.

Your credit score is likely to matter more when you apply for a conventional construction-to-permanent loan than it does for a government-sponsored loan program. Ideally, you’ll want a score above 700, with a score over 740 being ideal. The higher your score, the less risky you look as a borrower. That can mean you get a lower interest rate and better loan terms from a lender.

Should you decide to go the conventional mortgage route, you have two options, depending on the value of your home. You can apply for a conforming loan, meaning the price of your home falls under the limits set by the Federal Housing Finance Agency. The conforming loan limit changes annually based on inflation. It is higher in areas with a higher cost of living and cost of homeownership.

If you’re planning on building a large, luxurious home, it’s likely that the cost of the project and the appraised value of the house will be above the conforming loan limit. In that case, you may be required to apply for a jumbo loan or a non-conforming loan. Jumbo loans can be up to $2 million. Since jumbo loans are above the limit, they don’t have the same protections as conforming mortgages. As a result, they often have higher interest rates and might require a larger down payment from the borrower.

Apply for a Construction Loan With Assurance Financial Today

Your dream home can be closer than your think. Assurance Financial offers several construction-to-permanent loan programs that will provide you with financing to build your home from the ground up.

We also offer an easy online application process. In just 15 minutes, you can see what your eligibility is. Get started today so you can begin your new construction project.

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Assurance Financial Blog