How Do Construction Loans Work?
This post gets into the nitty-gritty details of how construction loans work, from preparing your loan application all the way through project completion.
We will cover 4 steps:
- Qualifying for a Construction Loan
- Preparing to apply
- Draw Schedule & Approvals
- Converting to a permanent mortgage
Step 1: Qualifying for a Construction Loan
We’ll review qualification in two parts: The Basics & Loan-To-Value.
- RESIDENCE TYPE: Construction Loans are for owners who are planning on living in the home (either primary residences or vacation homes). These are not fix & flip loans (for those types of renovation loans, we recommend Lending Home), but are loans that can be used to help long term owners find ways to pay for a home renovation.
- CREDIT SCORE: As you’d imagine, accessing the best construction loan rates requires a strong credit score (generally above 700+). But those with lower credit scores (580+) can also learn how a construction loan works for them by exploring additional options.
- DEBT-TO-INCOME: This is the comparison of your income and debt payments and it’s at the crux of not only construction loans, but most other lending. Construction loan approvals typically allow less than 43% of your income can go towards your proposed house payments plus all other debt. For example, if your income is $10,000 per month, your future house payment + auto loan payments + student debt + credit card bills should not exceed $4,300 per month (43% of your $10,000 monthly income). Click here to calculate your Debt To Income Ratio (DTI).
Just like a normal mortgage, the Loan-To-Value ratio is key for understanding how a construction loan works. This ratio is simply referring to what % of the home you will own and what % is being borrowed. So if you buy a home and put 10% down, the Loan-To-Value is 90%. Luckily with how construction loans work, we get to use the expected future value of the home, after the renovation.
Let’s look at a simple example:
The Jenkins family:
- $250,000 Construction Loan
- Their current mortgage balance is $350,000
- They expect the home to be worth $750,000 after the construction.
- Their total mortgage is $250k + $350k = $600k.
- Thus, their Loan-To-Value is $600k/$750k = 80%
Each lender sets their own Loan-To-Value requirements. Generally 80% is the max, but there are several options for going all the way up to 90–95%.
Depending on your situation, you might be able to finance the entire project with a construction loan or you might need to use cash in addition to the construction loan. Obviously if the cost of the renovation is more than you can borrow + cash you have, you won’t qualify.
Step 2: Preparing to apply
Applying for construction loans is everything you would expect about applying for a mortgage plus some steps that are unique to how the construction loan process works.
Construction loans ultimately are a type of mortgage loan. Whether you are using a construction loan that results in refinancing your entire mortgage or a renovation home equity loan that acts as a second mortgage (and leaves your current first mortgage in place), in either case it’s still a mortgage. And as with any mortgage, you will be required to provide the typical income and asset documentation.
This post specifically covers the elements you will need outside of a typical mortgage application that are specific to the construction loan process.
For homeowners, with how a construction loan works, banks are your friend. They want to be sure the builder you’ve chosen has a strong reputation and track record before they approve the construction loan. This extra level of scrutiny gives homeowners additional peace of mind and supplements any diligence they did on their own. Once a builder is approved by a bank, they don’t have to be approved again. If your builder/general contractor is not already on the approved list of the bank you are applying to, you will need to get your builder approved.
Your banker will provide their own specific forms, but generally, the builder will need to fill out an application and provide the following:
- Documentation of the builder’s licenses
- Documentation of general liability & workers comp insurance
- References from past clients & material suppliers
- Documentation proving they are current on their payments to subcontractors
Home Renovation Plans
In order to estimate what your home will be worth AFTER the renovation is complete, the bank will need detailed plans of what the project will entail and how the construction loan is being used. These plans ultimately will be handed over to an independent appraiser who is responsible for coming up with that estimated future value.
In conjunction with your builder, you will need to provide the following:
- Blueprints/building plans & detailed specifications
- Fully executed contract between you and your builder
- Building permits if applicable
- Contracts for all estimates outside of the construction contract
Step 3: Draw Schedule & Approvals
There are unique aspects in how a construction loan works even in how you can access the funds to pay your builder. This is good because the bank is looking out for you (and their own interest). Even though they’ve approved your builder, they are still cautious which helps protect you as the homeowner. Let’s say you are doing a $200,000 renovation. The bank isn’t just going to cut a check to your builder for $200,000 just like you wouldn’t if you were paying in cash. Instead you’d pay as the project progressed, based on certain milestones, thus reducing the risk for both you, the homeowner, and the bank. This helps them ensure that the construction loan funds are being used to enhance the collateral - your renovated home.
With a bank, this is done by creating a draw schedule. Using the $200,000 example, a draw schedule might be broken down into five $40,000 payments. Each payment corresponds with a milestone being met within the home renovation project. Once the builder has hit the milestone, they request the draw from the bank. With each draw request, the bank will send a certified inspector to your home to verify the work was completed and completed well. This creates a fantastic set of checks & balances that protects both the homeowner and the bank and it’s an integral part for how construction loans work.
Step 4: Converting to a permanent mortgage
For the sake of this blog post, we are assuming this a construction loan with a single close. What is a single close? Construction Loans are actually two loans in one.
- Construction Loan: Construction loans are short-term loans that cover the construction period, usually up to 12 months. Typically borrowers pay interest only during this period.
- Permanent Mortgage Loan: These are most typically either traditional 30-year fixed mortgages or 10 to 20-year Home Equity Loans.
A single close simply means it’s one construction loan that combines both of the above loans, so as the borrower you only have to pay closing costs/fees once and only have to deal with one set of paperwork. While separating the two loans and having two closings with two sets of closing costs/fees could make sense in very specific situations, in our experience the vast majority of time single close is the way to go as it saves homeowners time & money.
Once the construction is complete, the loan automatically converts to the Permanent Mortgage Loan. It’s that simple!