Buying a home that is already built, and building your dream home are two different things. If you choose to build your dream home, you may find yourself signing a construction loan. Construction loans are structured uniquely, and they have interest rates and payment requirements that are not always the same as a traditional mortgage.

By exploring the circumstances surrounding home construction loans, you will understand how to prepare for home construction and permanent financing before you start drawing up floor plans.

How Do Construction Loans Differ From Traditional Mortgages?

Home construction loans are typically short-term, while mortgages are long-term. With a home construction loan, the lender is expecting that the money will be paid off very quickly, often within six months or a year. Some lenders refer to this kind of loan as “interim construction financing,” indicating that it is simply designed to get a property ready to have a home built on it, building the home, and then having a buyer take occupancy.

The construction loan may be set with an adjustable interest rate that changes over a specific period. If you open a home construction loan, you may be able to negotiate an interest-only arrangement, thus allowing for smaller payments while the home is being built. The construction loan often works much like a line of credit with very detailed terms. The amount of the loan is usually based on the price of the property if you need to purchase it, plus the estimated construction expenses.

Who Can Get a Construction Loan?

Responsibility for the home construction loan depends largely on the size of the builder. Some builders use construction loans for themselves and then have buyers obtain and close on a new mortgage for the home once it is completed.

However, if you are using a smaller builder to construct a custom home, you might shoulder the burden of the construction loan. Smaller builders may not have the ability to open large, short-term lines of credit.

Can a Construction Loan be Converted into a Mortgage?

You may be able to convert a construction loan to a regular mortgage. To do this, however, you’ll need to either use a lender who handles construction conversion mortgages, apply for a mortgage with a different lender to pay off the construction loan, or refinance the construction loan. Once construction has been completed and the loan has been converted, it takes on the characteristics of a traditional mortgage.

Some lenders will grant you a one-time-close construction loan, which opens one loan for construction and mortgage together. These loans may have different financing for the construction portion and the permanent financing, but you only have one set of closing costs to pay in most cases. However, these loans may have terms that are difficult to negotiate after completion. As such, if you want a one-time-close loan, be cautious to ensure that your costs and timeline are very tightly planned and unlikely to change.

What is a Home Renovation Loan?

Construction loans can also be used to renovate or rebuild existing homes on property, and these can work in different ways. You may decide to get interim construction financing to allow you to purchase land and then renovate, repair or restore an existing home on the property. An example of this would be purchasing property with a home and building a new structure where the old house stood.

Renovation loans may also apply to land that you already own. If you have a current mortgage for an existing home, you may refinance the loan to allow you to build on the property.

How Can a Home Buyer Qualify for a Construction Loan?

Seeking a construction loan often means using the services of others professionals or companies. Lenders typically require home inspections and appraisals on existing homes to ensure that the property is a good investment. Trust in these outside professionals is important. Because, in effect, you and your building team are approved for the loan if the lender can approve your contractors to build your home in the time they estimate, keeping tightly to the budget.

In addition, when applying for a construction loan, you must demonstrate credit-worthiness and a steady income – just as you would if you applied for a regular mortgage. If you do not already own the land on which you are building, you should typically expect to make a down payment of 20-25 percent of your predicted expenses.

How Much Can I Borrow?

Mortgages are based on a maximum loan-to-value (LTV) ratio. Of course, LTV’s are a bit more difficult to determine when the home itself has not yet been built. For the initial financing, the lender will likely grant a line of credit based on the contractors’ estimates, and also comparisons to actual pricing in the area for similar construction.

If you plan to convert the construction loan to a mortgage, the lender may require an appraiser to determine future value. The value determines the maximum amount that the lender will approve, and the total of your expected down payment. The appraiser usually will make an estimate of the property no more than 120 days before permanent financing closes. If the appraisal is completed more than 120 days but less than 12 months prior to the effective date of permanent financing, the appraiser may perform an exterior-only update of the appraisal instead.

What Extra Paperwork Is Involved in a Construction Loan?

Before applying for construction financing, have all the paperwork from the contractors and builders that you plan to use on building the home. Get floor plans, detailed contractor bids with costs of materials and labor, and a tentative draw schedule for the rate at which you will need money disbursed. Also, be prepared to obtain general liability insurance and builder’s risk insurance for the construction. This insurance protects yourself and your investment from any damage that occurs during construction. Ask all contractors to show proof that they are properly licensed and carry worker’s compensation insurance for their employees.

Getting a home construction loan is a bit different than applying for a traditional mortgage. You will probably need to be sure that the home will be built on time and at budget, and that you are prepared to make the payments on the loan. With all the necessary information, you can build your dream home and then usually obtain a long-term mortgage after your home has been constructed.