Many of us have the dream of building our own house from scratch exactly the way we want it. But before you do anything, you need to work out how you’ll finance it – and funding construction can be difficult.
The main reason for the difficulty is the risk involved in your bank. There is a degree of uncertainty as the bank is lending money based on an assumption that your property will attain a certain value on completion. There are many factors that can change this, such as if property values dip or the work carried out is not of a good standard, and in these cases, the bank will have made a bad investment as the loan exceeds the value of the property. For this reason, construction loans usually come with higher interest rates than a traditional mortgage.
You can take the DIY route by doing most of the work yourself, using professional tradespeople (like plumbers and electricians) where you need to, or you can oversee and manage the process by employing a surveyor, architect, and tradespeople who will do the work for you. Another option is using a contractor to manage everything for you.
How do construction loans work?
When the construction loan has been approved, the lender starts to pay out the money as per the loan agreement. Rather than one upfront payment, this is done at intervals called draws.
Throughout the duration of the build, there are usually several draws. As an example, they may pay 10% when the loan closes to the builder, the next 10% when the foundation is set, the next portion of funds when the house is framed, and the remaining loan amount when the house has been sealed up.
The number of draws and payments included in each are agreed by the bank, builder and the buyer. Standard protocol is that the first draw is funded by the buyer’s down payment – that way the risk is with the buyer and not the lender. The bank might also organize an inspection before each draw to ensure everything is on track and will only pay out the next draw when they are satisfied that things are moving at the right place.
The qualifying requirements for a construction loan are quite strict to protect the bank and typically include the following:
1. The project builder must be qualified
They must be a licensed contractor with an established reputation. If you plan on acting as your own general contractor or are in an owner and builder situation, it could be hard to persuade the bank to finance your project.
2. You need to provide detailed plans to the lender
This can include anything from information around the materials you’re using, floor plans, the height of the ceilings to the type of insulation you’ll be using in the property.
3. An appraiser must estimate the value of the building
It can be difficult to estimate an end value figure as the building doesn’t exist yet – but the lender will need an appraiser to do this based on the building specifications and the value of the land you are building on. Often, they’ll compare their calculations with comparable buildings around the same area with similar features and size and then adjust this figure.
4. A sizeable down payment
You are likely to need a minimum of 20% for a construction loan – in some cases even 25%. This is to show that you are really invested in the project and if things go wrong, you won’t just walk away. It also acts as protection for the lender or bank in case the building is worth less than the estimated value.
By meeting these criteria and, of course, having a good credit rating, you should be able to qualify for a construction loan. The lender will also usually require information on your income, as with any type of mortgage, so that they can assess whether you’ll be able to afford the repayments.
What are lenders looking for in a construction loan application?
First things first – some experience. You need to show you understand the costs and that you’ll be able to maintain control throughout the project. Developers lacking experience usually underestimate the costs involved when planning. Proposals can be complex if you’ve not put one together before, so a lot of financers won’t even consider direct applications.
How long until I get the money?
This varies. If you are organised, meticulous and realistic, the process can be incredibly quick, and sometimes even completed entirely online. Depending on the circumstances, the lender and the nature of your project, you could have access to the funding within a few weeks.
Can I use a construction loan for a home renovation?
Yes, but make sure you do your research as there are other options out there. As with most things, it pays to shop around, so make sure you’re getting the best deal!
Are there any downsides to construction loans?
There are a few things to be aware of when seeking a construction loan. For example;
· The property may not be completed on time or within the allotted budget. If the work takes longer than anticipated, you might need to pay a fee to the lender to extend the loan.
· The construction costs might exceed the value of the finished building. This could be because the market fails or the builder is not up to scratch. If this happens, you would need to find extra capital to refinance the construction loan into an end loan.
· Non-eligibility. If your income or credit changes during the time of the project, you might have your end loan application declined. Construction loans are not intended to be permanent so this could create a problem. If you aren’t able to pay the balance by refinancing and the lender refuses a loan extension, they could assume ownership of the building.