Overview—Top 6 Tips on How to Get a Building Loan to Build a House
The idea of building your dream home from the ground up can be very exciting. The possibilities seem endless, which may feel a little overwhelming.
During the process, you will need to consider many things, from which kind of flooring is best to which contractor is best for you. You will also need to know how to get a building loan, how these home-building loans work, and which options will be best for your home.
It can be a bit of a challenge to find information about home-building loans online. This is because building loans make up a very small percentage of the housing market and because they hold higher loan-to-value risk for the lender.
This also means that there is not as much of an opportunity to shop around for different offers or rates. Because it is not as desirable an investment and such a small part of the market, lenders have not put a lot of effort into marketing home-building loans or attracting borrowers.
Common questions that people have about loans for building a home include:
- How do home-building loans work?
- What kind of loan for building a home will be best for me?
- Will I need a mortgage?
Knowledge is powerful, and with the right information and tips, finding the best loan for building a house will simply be one more item that you have checked off your to-do list. Once you understand how they work and what to expect, choosing the right one for you will be a snap.
Then, you will be able to focus on building your dream home instead of wading through finances.
1. Know How a Building Loan Works
If you are planning to build your own home, chances are that you will need to take out a home-building loan.
To find the best building a home loan for your project, it is important to understand how home-building loans work and how they are different from traditional mortgages.
Building a house is much more complicated than purchasing an existing structure, and in the same way, a home-building loan is more complicated than a traditional mortgage.
A loan for building a house only lasts for the length of time it takes to actually construct your new home. Instead of giving you a large lump sum, a building loan works more like a credit line than a traditional mortgage.
Image Source: Building a Home
A borrower will be approved for up to a certain amount and then be able to withdraw funds up to that amount at intervals as construction progresses.
Because it is possible for a home to be completed without using the maximum money available, you will only end up paying interest on whatever money is actually withdrawn. For example, if a borrower was approved for a $200,000 loan for building a house, but only withdrew $50,000 for construction, they would only pay interest on that smaller amount.
Also, if the plot of land has not been purchased beforehand, the purchase price can be included into the home-building loan.
It is important to understand that home-building loans are usually accompanied by traditional mortgages. Loans for building a house become due in their entirety at the end of the construction period.
There are no prepayment penalties for home-building loans—if you have the means to pay it off at the end of the term, you could do that. However, if you are not working with that kind of capital, you can take out a traditional mortgage to pay off the building loan.
2. Understand the Different Kinds of Building Loans
There are a few different kinds of home-building loans available on the market today. Each kind has its own advantages and challenges and might work better for one type project than for another. In order to make an informed decision about which kind of building loan is best for your project, it is important to understand what makes each kind of loan different.
All house building loans can be divided into two categories:
- Conforming: A conforming building loan is simply for any project less than $417,000. These home-building loans are easier to qualify for and have few restrictions. Because a lender is asked to risk less money and jump through fewer hoops, it is also much easier to find a lender willing to work with a conforming loan.
- Non-conforming: A non-conforming building loan has a credit line of more than $417,000. This loan is much more complicated and restricted. This kind of loan also carries higher risk for a lender, so it can be harder to find a company willing to work with this kind of loan for building a house.
Conforming and non-conforming home-building loans are only delineated based upon the amount of money being borrowed. Home-building loans can be categorized once again based upon how they will relate to the inevitable mortgage. Building loans can be complicated, and it is very important to be as specific as possible when determining what your needs will be.
Traditionally, home-building loans can be paired with mortgages in two ways: a one-step or two-step loan.
With a one-Step building loan, the borrower is choosing to use the same lender for both the loan for building a house and the mortgage. It is called “one-step” because you fill out all of the paper work for both at the same time—in one step. When you close your one-step building loan, you simultaneously close the mortgage for your home.
This kind of loan for building a house can be a better choice if the borrower or builder is fairly certain of the exact amount of time and money it will take to complete the project. There is no room for error and no flexibility in the amount of credit offered for the length of the loan. This is because the mortgage must start on its intended date, and the building loan cannot be open at the same time.
With a two-step building loan, the mortgage is done as a completely separate transaction, potentially by a different lender. Since the mortgage does not close until after construction is complete, the two loans are not able to interfere with one another. This means that more flexibility can be offered if the terms of the loan for building a house need to be expanded or changed.
3. Qualify for Your Building Loan at the Right Time
The first thing to do when applying for a building loan is to find a reputable lender. A consultation with a mortgage advisor at a good lending company can help you decide how much you would like to borrow and what kind of construction project you can afford.
It can be helpful to do this before you speak to a contractor so that you do not end up making unrealistic plans that you will not qualify for.
To qualify for a loan for building a house, a lender will look at your personal finances. Generally, they will look at your debt, income, and assets in order to determine how much you can realistically pay back on a loan, and therefore how much they can allow you to borrow. Qualifying for a loan is non-binding: you have not been officially approved, but the lender has given you an estimate as to what you can expect to be approved for in the future.
After you have qualified and you know how much you can borrow to build your home, it is time to find a contractor. You will need to have a signed contract and solid building plans in order to apply for your actual loan.
The contract is necessary to apply and close your loan because certain aspects of the construction process will affect your loan for building a house terms, such as the start and completion dates and the contract amount.
4. Hire a Reputable Contractor
This is your home and your project, but your contractor controls a huge amount of the actual action. It is important to make sure you are working with an individual or company that will do everything possible to stay on schedule and budget while also providing you with the home of your choice.
You will need to put a lot of trust in your contractor, so make sure that you choose a professional who is worthy of that trust.
Your contractor and lender will not be completely isolated from one another. The contract that you draw up with your builder will play a large role in the building a house loan application process. Your lender will require that they see a copy of the construction timetable, building plans, and the project budget. All of these items have to be approved by the lender before you can close on your house-building loan.
In a very limited way, your lending company will be a part of the construction process. The release of funds from your building loan is controlled and will follow a draw schedule to ensure that funds are only taken once they are needed. As construction progresses and additional funds are requested, a representative of the lender will often view the building site to evaluate construction progress.
5. Understand Your Qualification, Down Payments, and Rates
Home-building loans are much less common than traditional mortgages. They are riskier and less attractive to lenders, which gives them less incentive to make offers or rates competitive or appealing to borrowers. Since the loans carry slightly more risk for lending companies, they also have less ability to offer low rates without compromising their profits.
Image Source: Home-building Loans
Interest rates for home-building loans tend to be much higher than traditional mortgages. These rates are variable and fluctuate with the prime lending rate at large. Interest rates for home-building loans are calculated based on a number of different factors.
Interest rates can be negotiated but are generally based on your credit portfolio, financial history, income, and the equity of the construction project.
House-building loans are also more restricted in the amount of financing that they are able to offer. Some kinds of loans, like those offered by the FHA, VA, or USDA are able to finance 100% of the property value. However, a building a home loan will only cover up to 80% of the construction value.
This means that at least 20% of the property value will need to be covered by the borrower. This leftover value can be covered by an out-of-pocket payment, or it can sometimes be covered with some kind of equity.
6. Keep an Eye on Your Finances
As you look at taking out a new building loan, it is essential to pay close attention to your finances. Your debt-to-income ratio and credit score are both taken into special consideration when you apply for a building a house loan and mortgage.
Any fluctuations that occur between the time you apply for your building loan and close on your mortgage could make a world of difference in your qualifications.
When applying for new loans for building a house, it is important to keep in mind that the amount of debt that you already carry will affect your qualifications. For example, if you have a mortgage on your current home, whatever you still owe will be added to the total amount that you hope to borrow for your building loan. If the coupling of those two loans pushes your debt-to-income ratio too high, you might not be approved for your loan for building a house. If that does happen, you may need to sell your current home before you take out your building loan.
Because loans for building a home inevitably involve many steps and evaluations of your credit profile, be sure to keep your debt-to-income ratio in mind throughout the entire process.
Try to limit any large purchases during the building and application process. If you add to your personal debt during this time, it could change your qualifications.
Just as it is key to maintain your debt-to-income ratio, you will want to pay close attention to your credit score. Make sure you pay all of your bills on time because even a small change in your credit score has the potential to change your loan qualifications. This is particularly important with a two-step building a house loan.
If something happens to change your credit score after you have qualified for the loan for building a house of your choice, you might fail to qualify for the mortgage that you will need to finance your new home.
The credit limit attached to your building loan is important. When your building a home loan is finalized, it means that your lender has approved you, but you have only been approved to borrow up to the credit limit of your loan.
If new costs come up during construction that pushes the price over your limit, you may need to finance them yourself. Be sure to keep your building loan’s limits in mind throughout the whole process.
It is crucial to have a back-up plan for unexpected expenses. Home-building can be a very uncertain process full of unpredicted costs and unforeseen complications. Plan for these additions so that the building process can continue despite unpleasant surprises.
For that matter, life can also be full of costs and needs that you were not expecting, so even if your building process is absolutely perfect, it is a good idea to have some wiggle room in your budget, just in case.
Building a new home can be a very lengthy and complicated venture. Having a solid understanding of how to get a building loan and how to choose the best one for you can be a huge help throughout the process. With the right information and tips, you can make tough choices about loans for building a home quickly and easily.
Keep our 6 tips in mind:
- Understand how building loans work
- Choose the right loan for you
- Know when to apply for your loan
- Make sure you have the best contractors
- Understand rates, qualifications, and down payments
- Keep an eye on your finances
Building a home will be a unique process for each person. The process of how to get a building loan and knowing which kind will be best for your project can be complicated. The best way to navigate an undertaking like this is to come to the table with the best information possible.
The more you know about building loans, the better equipped you will be to make decisions for your own situation.
AdvisoryHQ (AHQ) Disclaimer:
Reasonable efforts have been made by AdvisoryHQ to present accurate information, however all info is presented without warranty. Review AdvisoryHQ’s Terms for details. Also review each firm’s site for the most updated data, rates and info.
Note: Firms and products, including the one(s) reviewed above, may be AdvisoryHQ's affiliates. Click to view AdvisoryHQ's advertiser disclosures.