Understanding Construction Loans

What are the requirements for a construction loan?

The requirement in settling for a construction loan is based on the type of loan you choose as there are two types:

Construction-to-permanent:

For this kind of loan you borrow to pay for construction but when you move in the lender converts the loan balance to permanent mortgage making it two loans in one. It's also important to note that you pay interest on the outstanding balance only, although the interest rate is variable during construction as it moves up and down the prime rate. In the event the Federal Reserve raises or lowers short-term interest rates before the building is complete, your interest will also be affected. Since it's a permanent mortgage, you can opt for a fixed-rate or an adjustable-rate loan, and specify the terms. In general, many lenders call for a 20 percent down payment of the normal amount of the permanent mortgage, but some make exceptions.

Stand-alone construction loans:

In this type of loan, your first loan caters for the entire project and when it's time to move in you get a mortgage to pay off the construction debt. Some of the drawbacks of this type of loan are that you pay for two closings and two sets of fees. Another drawback is that you can't lock a maximum mortgage rate, which means you might have to pay more than expected if there is any rise in mortgage rates.

When you get a loan to build a home, the lender doesn't have any collateral during the construction; therefore they will want some details like the home's size, the materials used and the contractors and subcontractors that will do the work.

These requirements include:

A Qualified Builder Must Be Involved – These are licensed general contractors with established reputation for building quality homes. To protect yourself from shady builders, conduct due diligence on the contractor and ask for references, or contact the state attorney general's office or the Better Business Bureau for complaints levied against them or any lawsuits. If your intention is to be the general contractor, you will have a hard time getting a financial institution.

Detailed construction Specifications – Lenders need to have details about the materials that are to be used and floor plans. Put together a complete list of all details "blue book" which can include everything from ceiling heights to the type of home insulation you plan to use.

Estimated home value by an appraiser – It may seem difficult to appraise something that doesn't exist, and most lenders use an appraiser to assess the blue book and specs of the house and the value of the land. They use the calculations to compare similar homes with the same location, features and size called 'comps' to determine the appraised value.

Borrower's Ability to Repay Loan – Lenders will make sure you have enough savings to cover the cost overruns or the unexpected costs. The lenders would like to see proof of income and the amount of any other outstanding debt. These are compared in the debt-to-income ratio, which is calculated by dividing the fixed monthly expenses by gross monthly income. 36 percent is the rate most lenders like although some allow up to 45 percent depending on the amount to borrow.

Credit Score and Cash Reserve - Credit score requirements vary depending on the sum of the loan as the higher the amount of loan the higher the credit rating. When it comes to Cash reserve, Lenders are known to like cash reserve amounting to at least six months of payment, taxes, interest, and insurance.

Unfortunately in some instances even after meeting the general requirements, lenders may not approve your loan until some specific information to the construction process is availed. You can include land purchase and if you own the land you can attach a copy of the land deed as proof of ownership to increase your chances of qualifications.