How do construction loans work and what are the requirements?

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A construction loan is a short term loan that is used to pay for the construction of a residential house. Also a construction loan can be used for additions and remodels as well. On these projects, within the loan process, since the final collateral has not been built yet, the proceeds from the construction loan are dispersed gradually as the home is built. Basically the construction loan acts as a big line of credit. Before the project starts, there is a zero balance. As the lot is acquired, the foundation is dug and poured, the work commences. Money is dispersed from the construction loan to pay for the labor, builder and work done. As more work is done the balance of the loan climbs. When all the work is done and all the bills are paid, the final balance will get paid off by your long-term loan.  Interest on a construction loan also works just like the line of credit. You only pay for what you use and when you use it. For example, if you borrow $25,000 the first month for work on your house your interest is just on that balance not the entire amount of your construction loan. Also the interest payment usually isn't due each month but gets paid out of your construction loan just like a bill for anything else in the house. This is so that it's not cumbersome for those still selling their current residents to make 2 payments. So when the home is built, a long-term loan or a long-term mortgage is obtained about the construction loan and then your payment will commence on your long-term loan. Consider your financial situation before starting a new home build.

Construction Loan Requirements plans

There are seven steps to acquire a construction loan to build your home. Protect yourself just like the lender will.

#1 Lot Purchase Contract
In other words you have to buy a piece of ground. Either know how much it is, where it's and what is the legal address or description.

#2  House Plans

Those building plans need to be completed from a license party with the specifications. Home construction is not to be confused with a DIY project. Also consider the types of home available to build within your zoning.  There are so many building floor plan ideas to suit just about anyone's needs.

#3 Costs of Construction

A cost breakdown is generally coming from your builder. The Builder will tell you line item by line item literally from how much framing this will cost to roofing and everything in between. Those will be the numbers we use as we go through the process. We then have to have information on the Builder we want to make sure he knows how to build a house that he has experience in doing so and that he has all the insurances and liabilities in place just in case. There is a term called cost overruns. Check into costs to build thoroughly.


4. Information on the Builder

If you had any clue how many things that could happen in this process you want a contractor that you know will do the job, won't leave and will finish it. What happens if you had a contractor that tells you everything you want to hear upfront but halfway through has some personal problems and leaves? You have to then go find someone else and you're gonna be at their mercy. You don't want to be in that position. Who that contractor is is critical. I need to throw in here real quick some people say what if I want to do an owner builder. An owner builder is where you build your own house that is possible but the lending industry doesn't like it. Go with a qualified builder and take a look at their completed homes.

#5 Construction Contract
You have to have a contract. How much is the home going to be? How long is it going to take to build? What's included and what's not included. There are intense stages of construction to be aware about in the home construction loans process.


#6 Insurance Coverage
You need to have insurance to cover yourself just in case of emergency for your real estate project.

#7 Mortgage Loan Approval

To begin with in the loan process, it is crucial to have a long term mortgage loan approval. The loan amount you need for the final approval. You've got to have that saying upfront, yes I qualify for that and dollar amount when the home is complete. Also at the end of the home construction, the lender has got to make sure that it's all on time. Mortgage rates are very competitive right now so be sure to shop around with several mortgage lenders. You mortgage payment in the end is what you must be sure about.

construction loan process

Many construction lenders see minimum equity and cash reserve requirements differently. Here are the basic rules. It's always best to own the land free and clear if you can. If this is not possible, equity requirements in the land can range from 20 to 50% of the purchase price or value depending on the acreage and the availability of needed utilities like water well septic sewer and power. Cash reserve requirements are typically six to twelve months of your estimated principal interest taxes and insurance payment. It is wise to have 12 months if possible so you can pay for items in advance and be reimbursed later. Construction loan draws are basically a percentage of completion so sometimes cash can be your only friend while you are building. There are many mortgage lenders out there that can find the type of construction loan custom to your home build.

construction loan lots as equity

How a construction loan works when you are paying cash for the lot or own it free and clear.

In the loan process, there's not a whole lot that's different other than the fact of you know once your blueprints and your building contract are completed by your builder, that's going to go to the bank so the bank can start their construction loan process. If you're paying cash for the lot, instead of having to put down right now a lot of banks require as little as 5% down. So if you were going to be putting down 5% to get your construction loan started but you already own your lot or you paid cash for the lot, you already own it. The bank is going to take the amount that you paid for the lot and that's going to act as your down payment or as your collateral towards your down payment. So if you bought a lot for say $50,000 and you paid cash for it then that $50,000 you have basically land equity which can be applied towards your construction loan. You will still have to pay closing costs to the lender or bank. This is a separate fee that you have to pay so the equity that you have in the lot the $50,000 that you paid towards the lot acts as your 5% down payment. The closing costs are in addition to that 5% down payment. If you're working with a builder that requires a deposit up front which you know normally a lot of builders do. So most builders are going to require a deposit maybe it's couple thousand dollars to get everything started. So again that's separate from if you make that payment towards the Builder the bank does account for that as part of your down payment. But if you paid cash for your lot and you're not having to put any money down with the lender, you still have to put down the closing cost with the lender and then a builder deposit. So you're going to be taking out of pocket to get everything started. Even though you already bought the lot with cash. So make sure you still got a little bit of reserves left to go ahead and do that. If you bought your lot and you financed it so say you bought your lot you know two or three years ago and you bought the lot for $50,000 and you financed the lot and now a few years later you only owe $25,000 on the lot then the bank can go ahead and take the difference between what you still owe on the lot and what the Lots worth. So in this case with the $50,000 lot, if you owe 25 and you paid 50 and it's worth 50 the bank can take that $25,000 of equity and use that as part of your down payment.  When you do buy land, consider the size from the point of view of the lender. Many of the real estate agents here on activerain are experts in new construction. So be sure to browse around for their help.

construction loan approval process owner builder

Construction to Perm Transaction

There's a high demand for this type of product. There's two phases in new construction loan to build. Many lenders call this like to call this a Construction to Perm Transaction or constructiontopermanent loan. So what happens in that is there's two pieces of those two phases to the Construction to Perm. There's an interim financing loan amount and that's where all the construction financing is occurring. All the magic is happening right there. Then you've got the permanent financing. This is just like your regular permanent loan that you have today. When there's two pieces in this in this new construction to perm program in that there's a lot of moving parts. It's a little complex transaction, so you really wanted to work with experts in the field. Because they could turn this beautiful situation into a real tough situation and you just don't want that. You need a builder that knows what they're doing. You need a lender that knows what they're doing.


In a nutshell starting with the permanent financing, we're going to go backwards with this. We're going to form what we call a proper exit strategy. It's very important to know just like in any business situation to know what the exit strategy is. In this case, in the lending business, this is the permanent financing. You want to make sure when the home is built, when the certificate of occupancy is established, that you have a perm loan in place. So you actually start with permanent financing and have an actual mortgage loan to pay. You start with a regular credit approval as you would with a normal mortgage. The financial requirements usually require a underwrite with fico scores . But what is most important is what the appraisal is going to be in the whole application process.

A lender will most likely order the appraisal upfront. A subject to appraisal is ordered which the appraiser will look at plans,specs and do an assessment based upon a completed home. Even though it's not built yet. So within that they're going to look at the lot, construction budget and plans. An assessed value will be determined based on current comps today. Lastly on the permit finding pieces the rate lock. Usually in a bill depending upon the size of the house it will be four, six, nine or 12 months construction terms. That's usually how long the builder is going to take to build. So as an example a lender will lock that rate up to nine months. For some reason at all if rates are lower, when you when the house is built a lender will roll the rate down. That's a four six nine and twelve months construction term loan amount. So most construction loan lenders will do a float down.

Focusing in on the interim financing. This is the second phase of the construction to perm process. There's about four different elements here. In the end it's all about the permanent mortgage.

1.Perm Approval
2. Plans/ Specs
3. Builder Registration
4. Fund Control

va construction loan

Build a new home using VA Construction Loan

If you're looking for a VA construction loan lender there are some lenders which offer 100% financing on one single closing va construction loan to buy land and build a home. The Veterans Angel Program and Dream Weaver home purchase program are fully custom renovated home programs that offer zero down and zero closing.

Why is it so hard to find a lender to do a VA construction loan? Not every lender can or wants to do VA loans period. Compared to a VA purchase loan or especially compared to a VA Streamline refinance, these VA construction loans are a ton of work. Usually ten times the work of what's called a streamline refinance. So no one wants to do these loans. The second reason is VA loans are loaded with risk.

But when you understand the lenders risks, you're better prepared to work with a VA lender and design your transaction for success. First know that lenders are in business to take measured risks and return for profit. They experience a loss on a VA loan when they have to foreclose and the losses from dumping the property exceed 25% of the original loan amount which is guaranteed by the VA. Lenders don't like to lose money.

VA construction loans take this possibility of foreclosure risk to a whole new level. Starting with the economic risk. It can take nine months after you buy the land to build a home. What if the economy takes a dive? What if you lose your job during construction? What if property values begin to soften right as the loan funds to buy the land? These are real risks when you have loan to pay. VA construction financing is definitely more available in a better economic environment and a thriving economic region. So the lesson is if the economy dumps this program may disappear.

Property appraisals. 
Many people who want to build using VA financing own lots of acreage. The more acreage the less likely that lenders are able to assess properly. A perfect appraisal is achieved with a tract home which has several very recent model matched sales inside the same development. Underwriters are really comfortable with the assessment of that property's value. A bad appraisal with uncertain value is created when sales are infrequent with lots of different size land or acreage all over the place. With comparable sales located in large Geographic footprints away from the subject property. The more land the less appealing. Underwriters are much more comfortable with the concentration of the value being in the dwelling. In the house not excessive acreage which has less appeal to the over all home buying public. Should the property need to be foreclosed and resold. If it's going to be a manufactured home installation or a modular home build your comparable sales on the appraisal should be the same type of property. The lesson is find a parcel of land which already resides in an area of reasonable housing density where the same types of properties are being bought and sold frequently. This can be kind of hard to do sometimes because the land is where the homes typically are not. There's contractor or builder risk. Just how stable and dependable is their work their likelihood of finishing the project on time or on budget. VA lenders don't want to take over an incomplete construction project that's a hundred percent financed. That's their ultimate nightmare. Choose a reputable builder which meets all the upfront qualifications so a friend with a state contractor's license who's done a couple large remodels, probably is not going to be sufficient. Often the biggest risk, lenders are of course concerned about you as the borrower. Who will repay the loan? Although VA underwriting guidelines allow for more lenient credit standards, if your employment history is scattered and you don't have enough savings or much savings at all. Your credit is a bit beat up you're less likely to achieve your goal of building a home. Perhaps purchasing a resale home might be more realistic. Now strong borrowers have great job stability, high income relative to proposed debt payments and no credit blemishes.

Beware of bait lenders

Beware of some lenders who bait you into thinking that they can help. But when you get right down to it they say oh go find a construction loan. Then when the home is built we'll get you a permanent VA loan. That's a two-step process. That's two loans. A typical construction loan that requires a big down payment which you probably don't have. They're hoping to draw you in and switch to something more simple. If you look hard you can find a lender who will offer a single close, 100% financing VA construction to permanent loan. But to get it done, you're going to have to put together a project that focuses on minimizing all the lender risks. A va home loan can help many people, so be sure to check them out.


Contact me if you need help finding the right lender who can provide great home construction loans, mortgage payment, with mortgage rates, when building your own home. Maybe you have an existing home and looking to build new. I know some great real estate agents with new home construction experience that can help. Thank you for reading about how to build your dream home with a construction loan. Be sure to comment below.


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William Feela
Realtor, Whispering Pines Realty 651-674-5999 No.

V ery good outline and explanation.  Watching out forscammers that make a deal sound to good is a must

May 08, 2018 05:35 AM #1
Nina Hollander
RE/MAX Executive | Charlotte, NC - Charlotte, NC
Your Charlotte/Ballantyne/Waxhaw/Fort Mill Realtor

Great post... so many people really have a poor to no understanding of how construction loans work and there really are not all that many lenders who actually do them, so it's no wonder.

May 08, 2018 05:58 AM #2
James Grant
Asheville, NC

Hello,  Excellent post. Some lenders are trick others, that is their business. Thanks for sharing!

May 09, 2018 04:55 AM #3
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