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Guide to Home Construction Loans

April 20, 2022 By: Great Midwest Bank
toy bricks form a house sitting on top of blueprints

Building your own home is an incredibly rewarding experience. Hard hat on, you’re in the driver’s seat of the concrete mixer, ready to pour the foundation for your new home. Well, metaphorically speaking. YOU determine the overall design and layout, personal flair like unique lighting choices, and maybe a zen garden out back. Because that’s your thing, and this is your dream home.

While your new home is picture-perfect and finished in your head, the actual home construction may pose challenging moments. Will this be finished on schedule? Those weren’t the windows we chose, were they? But most importantly—how are we going to pay for it all?

So, let’s break ground by learning how home construction loans work and how Great Midwest Bank loan officers can help put your mind at ease.

You will be making lots of decisions. Lots! Like choosing the perfect location and the right builder, making neverending design choices, etc. But one of the most important decisions will be your home construction loan.

What Are Home Construction Loans?

Whether you’re building an addition to your existing home or building your dream home from scratch, you’ll probably need a home construction loan. These loans usually include higher interest rates and shorter-terms. They’re meant to cover the cost of building your home or other construction projects while you’re in the building phase.

Unlike traditional home mortgage loans, which are based on the fair market value of a home right now, construction loans are based on the projected value of the home once the work is complete.

There may be several different types of construction loans available to you:

Construction-to-Permanent Loans

This sort of construction loan lets you lock in the interest rate at closing, which makes for steady payments through the construction process. These loans are ideal when you already have construction plans and timelines put together. From there it’s a simple process. The bank pays the builder or contractor as the work is being completed. Then, that cost is converted to a mortgage at closing.

One nice advantage of a construction-to-permanent loan is that you only submit your financial documents (credit report, score, etc.) once. Plus, the closing only happens once as well, saving you thousands of dollars and all the hassle of submitting paperwork…we have a feeling you won’t miss that!

Construction-Only Loans

Construction-only loans are less common and require you to pay them off in full once the building is complete. It may be a good choice if you have a large sum of cash on hand or you anticipate the proceeds from the sale of your current home to cover the new construction costs.

However, if you need a mortgage to cover the cost, you’ll have to be approved a second time.

[Common Questions About New Home Construction Loans, Part 1]

What Are the Benefits of a Construction Loan?

While a traditional home construction loan is not your only option for financing your dream home, these loans do come with some benefits. Let’s briefly cover those.

Interest-Only During Construction

During construction, you’ll just be expected to pay lower, interest-only payments on the loan, since the loan isn’t paid out in full until the new construction is complete.

More Structure Equals Better Results

The added scrutiny with a construction loan may not seem like a good thing at first, but during the building process it can actually help ensure your project stays on budget, on schedule, and hopefully help you avoid any headaches.

Are There Drawbacks to a Construction Loan?

As with any loan, there are pros and cons—or special considerations—for each option. Here are a few things to carefully considered related to construction loans.

Higher Qualifying Standards

Since home construction projects often cost more than an average home mortgage, they often come with higher qualifying standards in terms of credit and down payment. Typically, a score of at least 680 and a down payment of at least 20% is needed.

Higher Interest Rates

Construction loans typically have variable interest rates that correspond to a certain percentage over the prime rate. For example, if the prime rate is 4% and your loan rate is prime plus 2%, you may pay 6%.

Shorter-Term Risk

If you’re going for a construction-only loan, remember that at the end of the loan term you will need to pay off the loan in full. That’s usually covered by a separate mortgage, but you’re responsible for the full amount, even if your original financing falls through.

[Five Frequently Asked Questions About Renovation and Construction Loans]

How Do Construction Loans Work?

Traditional home loans are paid out by a mortgage lender to cover the cost of the home in one lump-sum at closing. Construction loans, on the other hand, are paid out in installments. Your bank pays the builder as various phases of the building process are completed. Then, the total cost is transferred to you once the entire project is finished.

These installments are called “draws.” Each draw reimburses the builder for the costs of completing a particular phase of building. Before each draw can be made, your lender requests an inspection to make sure things are going well. These inspections verify the estimated cost of the current phase of building, in addition to ensuring the builder is on schedule.

Getting Approved for a Home Construction Loan

The time has come to get approved and start building your beautiful home. The construction loan process is pretty straightforward. Your lender will evaluate a variety of documents related to your loan. As with a mortgage, you’ll want to have recent tax returns, employment income records, revolving credit balances, and bank account statements ready to submit.

Here’s what we may need:

  • Builder contract
  • Detailed architectural plans
  • Builder’s budget and specification sheet
  • Track record in building similar properties and construction schedule

Because your home’s construction is contingent on the builder’s ability to perform, the builder’s reputation and experience are key factors in your loan application package. Take the time to research a variety of builders and ask for references. That way, you’ll feel more confident in the loan application.

We also have experience working with many reputable local vendors in Southeast Wisconsin, and we’ll be happy to provide you with a list of recommended contractors. You’ll have peace of mind knowing that you’re working with a building company that will fulfill your dream home visions the right way.

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How Do I Access My Loan Funds?

Payments to your builder are made through construction advances under the loan terms. As each stage of work is completed, the builder will submit a draw request to the lender to pay for those costs. You and the builder are required to sign each draw request, but you never have to worry about handling the payments to your builder yourself. Those will come directly from your lender, be it GMB or another lender of your choosing, so you don’t have to worry about playing the middleman.

Still have questions?

This may all still sound like a lot, but we’re here to navigate the blueprints with you. We aim to make the process as stress-free as possible! Whether you’re simply thinking about building your forever home or you’re ready to start construction, don’t be afraid to talk with us. Our experienced Great Midwest Bank loan officers can answer your questions about home construction loans and help determine which loan option is the best fit for you.

Posted in  Home Construction Loans