If someone has told you that using a construction loan was the best way to finance your renovation project, you should really know all the facts.
You see, this type of loan sounds great because it lets you borrow based on the after renovation value of your home, helping you to finance your wishlist all in one go.
And until recently, these were the only real options for homeowners to borrow in this way. Now, other options exist, and these are typically better-suited for renovations.
Here’s everything you need to know about the ins and outs of construction loans, and the process you’ll go through to get one.
Step 1: Qualifying for a Construction Loan
The first stage of taking out a construction loan is qualifying for it, and in order to help you understand exactly how this works and what the specific criteria are, we’ll review this in two parts: the basics of construction loans and loan-to-value (LTV) ratio.
The Basics of Construction Loan Criteria
Here are the basics that you need to know about qualifying for a construction loan:
Construction loans are for owners who are planning on living in the home (either primary residences or vacation homes).
Construction loans are not fix-and-flip loans , but are loans that can be used to help long-term homeowners find ways to pay for a home renovation.
Construction loans are typically offered by community & regional banks. They typically require a higher minimum credit score to qualify, often 700 or above.
Debt-to-Income Ratio (DTI):
Your debt-to-income (DTI) ratio is the comparison of your income and debt payments, and it’s at the crux of not only construction loans, but most other lending too (in fact, it’s one of the most common reasons why homeowners can’t qualify for a RenoFi loan).
Construction loan approvals typically require less than 43% of your income to go towards your proposed house payments, combined with all other debt that you have.
For example, if your gross income is $10,000 per month (before tax), your future house payment + auto loan payments + student debt + credit card bills, and other debt repayments should not exceed $4,300 per month (43% of your $10,000 monthly income).
Understanding Construction Loan-to-Value (LTV)
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 the % of your home that you will own and what % is being borrowed.
If you buy a home and make a 10% down payment, as an example, the Loan-to-Value is 90%.
With construction loans, you are able to borrow based on the expected future value of the home, after the renovation, rather than the current value.
Here’s a simple example:
Meet the Jenkins family.
They are looking to take out a construction loan of $250,000 to pay for home improvements.
They expect their home to be worth $750,000 after the construction, and they have an outstanding mortgage of $350,000.
Their total mortgage, after works have been completed, will be $600k ($250k + $350k), making their Loan-To-Value 80% ($600k / $750k).
And it’s important to know that, while each lender sets its own Loan-to-Value requirements, 80% is generally the max, but there are some lenders that will allow you to go all the way up to 90%.
Step 2: Preparing to Apply
Applying for a construction loan is, in some ways, similar to applying for a mortgage, with some additional steps that are unique to this type of loan.
But ultimately, construction loans are a type of mortgage loan.
And as with any mortgage, you will be required to provide the typical income and asset documentation, and below, we’ll specifically cover the elements you will need outside of a typical application that are specific to the construction loan process.
Lenders want to be sure the contractor you’ve chosen has a strong reputation and track record before they approve your construction loan; they’ll want to approve your choice.
This extra level of scrutiny gives homeowners additional peace of mind and supplements any diligence they did on their own.
But once a builder is approved by a bank, they don’t have to be approved again, meaning that if your builder or general contractor is not already on the approved list of the bank you are applying to, they will need to go through an approval process.
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
Whilst a builder who is able to satisfy the requirements of the lender shouldn’t have issues getting approved, it can delay the application process.
Home Renovation Plans
In order to estimate what your home will be worth AFTER your renovation is complete, the bank will need to see detailed plans of what the project will entail and how the loan is being used.
These plans will ultimately 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
One of the big things that you need to know about construction loans is draw schedules and approvals.
You see, these loans are unique in the way you access the funds to pay your contractor.
Even though your lender has approved your builder, they are still cautious.
Here’s an example:
Let’s say you are doing a $200,000 renovation.
When taking out a construction loan, the bank isn’t just going to cut a check to your builder for $200,000 upfront.
If you were paying cash, you’d pay in installments as the project progressed, based on certain milestones, thus reducing the risk.
Lenders are the same.
This helps them to ensure that the funds are being used to enhance the collateral; your renovated home.
And they do this by creating a draw schedule.
Using the $200,000 example, a draw schedule might be broken down into five $40,000 payments, with each one corresponding with a milestone being met in the project.
Once the builder has hit the milestone, they request the draw from the bank.
And with each draw request, the bank will send a certified inspector to your home to verify the work was completed to the required standard.
In turn, while this creates a fantastic set of checks and balances that protect both the homeowner and the bank and is an integral part of how construction loans work, it ultimately causes delays in projects.
When the contractor makes a request for a draw, they have to go through the individual process for that specific bank, which chances are—they’ve never done before.
The bank will then order an inspection from a third party, which can take anywhere from a few days to over a week.
After the inspection, the contractor and the homeowner will have to sign approvals for the additional draw.
Step 4: Converting To a Permanent Mortgage
For the sake of this guide, we are assuming this a construction loan with a single close.
But 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 that 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 times, a single close is the way to go as it saves homeowners time & money.
Once the construction is complete, the loan automatically converts to a permanent loan.
It’s that simple!
But, that doesn’t mean that this type of loan is right for you, and in most instances, homeowners have better-suited alternatives available to pay for renovations.
Use our RenoFi Loan Calculator , schedule a call or chat online with one of our advisors today, and we’ll show you how you can benefit from a RenoFi Loan.
How do I know if a RenoFi loan is right for my project?
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