Common Questions About New Home Construction Loans (Part 1)
When you are searching for a new home, it can be easy to run into the “Goldilocks problem.” One house is in an amazing location, but it’s too small. Another home checks all your boxes, but you don’t want to maintain the pool that comes with it. If you have been struggling to find a house that’s just right for you and your family, you may opt to build your own.
Starting the journey toward constructing a new home can be exciting and overwhelming at the same time. There is a lot to figure out, like finding the picture-perfect neighborhood to build in, planning how you want your home laid out, choosing who is going to construct it, and making the difficult call on whether you want to go with a patio or a deck in your backyard.
Perhaps the biggest question, however, is how you are going to finance this home construction. Once you establish a Home Construction Loan, you can focus your energy on bringing your vision to life.
Let’s see what we can do to tip your home build more toward the exciting side! To demystify the Home Construction Loan process, we’ve answered some of the most frequently asked questions about our Home Construction Loans and what you can expect during the process.
What is a Home Construction Loan?
You will need to establish a Home Construction Loan if you’re building a new home from the ground up or building a large addition to your existing home. These loans usually have higher interest rates and shorter terms. They are meant to cover the cost of building your home or other construction projects when you are in the building phase. While Home Mortgage Loans are based on the fair market value of the home, Home Construction Loans are based on the expected home value once the home is built.
How do I apply for a Home Construction Loan?
Great Midwest Bank works to make the Home Construction Loan application process as straightforward as possible for you. You can apply online on our website, stop in at one of our local branches, or give us a call. Your lender will evaluate a variety of documents related to your loan.
To set up a Home Construction Loan, you will need to present detailed architectural plans, a builder’s contract, a reasonable budget and a timeline for the project from start to completion. Organize all these items beforehand so they are ready to go when you begin the loan application process.
Similar to a Home Mortgage Loan, you will want to have recent tax returns, employment income records, revolving credit balances and bank account statements ready to submit. Be sure to download the Great Midwest Bank loan checklist — it details all the documents you need to get started on a Home Construction Loan.
What are the requirements to qualify for a Home Construction Loan?
Home Construction Loans typically have higher qualifying standards than a home mortgage loan. Generally, borrowers will need to meet a particular credit score threshold. They will also need to be able to pay a certain down payment percentage.
The minimum down payment for a Home Construction Loan may be higher than that of a home mortgage loan. However, Great Midwest Bank offers some of the lowest down payment options among banks in the area. The down payment amount is due at the time of closing and your funds will be disbursed before loan proceeds are used.
How do Home Construction Loans work?
Rather than paying the full cost of the home in one lump-sum at closing like you would for a traditional mortgage loan, Home Construction Loans are paid in installments, or “draws.” Great Midwest Bank pays the contractor while different stages of the home build project are completed. When the construction wraps, the final cost is transferred to you, the borrower.
Every payment draw compensates the builder for a certain phase of the home build project. During these phases the bank will have inspections performed to ensure everything is on track as agreed. These inspections verify the estimated cost of the current building stage and also help make sure the project is still on schedule.
How do adjustable rate mortgages work?
At Great Midwest Bank, we offer a variety of adjustable rate mortgages (ARMs) for Home Construction Loans. These products include a “one-time closing” provision with a construction period of up to a year. The rate is locked for the initial term.
The interest rate will change over time, adjusting to the market. An ARM will generally have a lower rate upfront than a fixed-rate mortgage, but rates will fluctuate over time. That means payments may be less predictable from month-to-month.
When can I lock into a fixed rate? Are there extra costs for doing so?
An adjustable-rate mortgage is standard throughout the duration of your home construction. As the home build nears completion, you will likely be eligible to apply for a fixed rate refinance.
This refinance often comes at low or no cost to the borrower. Typically, Great Midwest Bank will use the original home appraisal for this purpose.
What does “one-time closing” mean?
When your home construction project comes to an end, Great Midwest Bank can combine your construction loan and permanent mortgage into one loan. This allows for “one-time closing.”
One-time closing is exactly what it sounds like — you will only have to do closing once! Therefore, you just submit your financial paperwork, including credit report, pay stubs and so on, one time. That means you could save money in closing fees and also save the time and effort of sending documentation multiple times.
Once construction is complete you begin to pay a monthly mortgage payment. You may want to consider a refinance into a fixed-rate loan upon completion.
What Home Construction Loan options does Great Midwest Bank offer?
Some of Great Midwest Bank’s Home Construction Loan options include:
A construction-to-permanent loan allows you to lock in the interest rate upon closing. This means you will have steady payments while construction is underway. These loans are considered the best option if your construction plans and timelines are already outlined. After setting up the loan, the bank pays the builder or contractor as the project progresses. During closing, that cost is then packaged into a mortgage.
Another upside of securing a construction-to-permanent loan is that you have one-time closing — you will have one closing appointment and only pay one set of costs.
Construction-only loans require that once the building is complete you pay the loan off in full. Although a less common option, someone may choose to go with a construction-only loan if they have a large sum of money on hand. Another potential reason to choose this type of loan may be if the borrower anticipates the proceeds from the sale of their current home to cover the new construction costs. Keep in mind that if you need a mortgage to cover the cost, you will need to be approved a second time.
What are the benefits of a Home Construction Loan?
Some benefits of a traditional home construction loan include interest-only payments during construction and the fact that these loans require more structure.
Interest-only Payments During Construction
While construction is underway, you will simply make lower, interest-only payments on the loan. This is because the loan will not be paid out in full until your home build is complete. With interest-only payments during the construction, you will have a lower monthly payment amount throughout the whole duration of the project. That is one less stress to worry about while you build your dream house!
More Structure Can Mean Better Results
Home Construction Loans do come with an extra layer of scrutiny from the lender, which might feel like a drawback at first glance. However, it can be a significant advantage during the building process. All the checks and balances can actually help ensure your home construction keeps within the budget and schedule you have outlined — which could save all parties from frustration, delays and expenses later on.
Are there any drawbacks to Home Construction Loans?
There are pros and cons to weigh for all financing decisions. Home Construction Loans tend to have shorter-term risk, higher qualifying standards and higher interest rates.
At the end of the Home Construction Loan’s term you will need to pay off the loan in full. Usually that will be covered by a separate mortgage that you set up. However, keep in mind that if your original financing falls through you will still be responsible for covering the full amount.
Higher Qualifying Standards
Home construction projects often cost more than the average home mortgage, and that means they often come with higher credit and down payment qualifying standards. Therefore, Home Construction Loans may be more difficult to qualify for than other loan products. Great Midwest Bank cannot guarantee everyone will be approved for a Home Construction Loan, but we will use a common sense approach to assess your financing options.
Higher Interest Rates
Home Construction Loans usually come with fluctuating interest rates that correspond to a specific percentage over the prime interest rate. For example, if the prime rate is 4% and your loan rate is prime plus 2%, you would pay 6%.
Can Home Construction Loans help finance home design expenses?
Unfortunately no, because to qualify for a Home Construction Loan you will actually need to have your home design plans laid out beforehand to present to the bank.
Any costs for the design phase of your new home fall outside of the home construction parameters. Therefore, you will need to fund home design and planning expenses through means other than the Home Construction Loan.
Could I use funds from the Home Construction Loan for anything else, like new furniture for the house?
Home Construction Loans only cover expenses related to building the house. In fact, you won’t deal with the funds personally. Great Midwest Bank will pay the builders directly through the loan. The builders get paid based on the construction costs as they work to complete the job. In turn, the borrower just pays interest on the amounts the contractors are paid.
When the build is complete you may pay less than expected if the project turns out to cost less than originally scoped for in the loan. However, you will not end up with an extra loan balance to use up for other purposes.
Will the equity in my lot be considered part of the down payment?
Most likely, yes — the equity in your lot may be factored into your down payment. This is because the appraisal will take into consideration the current land value. We will go over your specific situation and discuss exactly how everything breaks down.
Can I start building before selling my existing home?
Depending on the cash you have available and/or your home equity position, you may be able to do so. This is assuming that your income supports both monthly mortgage payments along with any other monthly expenses or debts you may have.
If you are not sure what makes the most sense for you financially, talk to a local loan officer at Great Midwest Bank. They will help you assess your current situation so you can choose the best option for your unique circumstance.
Can I make design changes to the construction plan once building has begun?
If you want to make changes to the construction contract, it will be processed as a change order. That means the contract price may be amended, and you would need to cover any costs above the agreed amount. Great Midwest Bank will need to review change orders for approval if the construction plan changes have a significant impact on home value or loan balance.
How much does a Home Construction Loan cost?
Standard fees for a Home Construction Loan are similar to that of a Home Mortgage Loan, but there may be an additional one-time fee for optional Owner’s Title Insurance. Typically the cost is around $1,500 plus a fee for Owner’s Title Insurance. The cost of this insurance is based on a standard statewide schedule.
What is Owner’s Title Insurance?
Owner’s Title Insurance protects you as an owner of the property and assures that your property is free of any liens, judgments and encumbrances other than the mortgage filed as part of the construction loan. It is purchased as a one-time cost at closing and is valid for as long you own the property.
We recommend Owner’s Title Insurance because it offers protection:
- From paying costs associated with defending anything the insurance covers
- Against monetary loss from covered claims
- In the event of title defects (anything that would render the title invalid in some way)
We hope that helped build up your Home Construction Loan knowledge!
Building your own home involves lots of steps, but is well worth it once you are settled into your perfect place. At Great Midwest Bank, we are honored to be part of your home construction journey. Apply online if you are ready to get started on a Home Construction Loan. If you have further questions or are ready to start building your new home, call your local Great Midwest Bank branch or stop in to speak with any one of our friendly and experienced loan officers. Our goal is to make your Home Construction Loan process as stress-free as possible so you can focus on all the other details.
A version of this blog was originally published in January 2019. It was last updated in June 2022.