Construction Loan Application

Construction Loan vs Standard Mortgage: How They Are Used

Finding the perfect house on the market in Colorado these days is more challenging than ever. We’re still experiencing a scarcity of homes for sale. Demand has remained high in Denver and the rest of Colorado. Even while the supply of houses for sale continues to stagnate. You may be able to relate. Maybe you have toured several places already and come up against disappointment for one reason or another. 

Ever fallen in love with a home only to get outbid by another buyer, finding yourself back at square one? Perhaps you have been shown a few houses, but you weren’t ready to get into an aggressive bidding war because the home didn’t have everything you were looking for. The home’s location and amenities matter, and you don’t feel like lowering your standards or settling. 

Or, maybe you have known from the start that you want to design and build your own home from scratch. If any of these scenarios fit your situation, you most likely are looking to build a house, which comes with a different set of challenges and financing nuances. Though, keep in mind, it doesn’t have to be difficult. We are here to discuss the financing options you will need to consider and prepare yourself for when building your home.

There are several different loan types to consider depending on your situation, timeline, and long-term goals:

  • Construction-only loan
  • Construction-to-permanent loan
  • Renovation loan
  • Owner-builder loan
  • End loan

Keep reading for the breakdown.

What is a construction loan?

A construction loan is a short-term loan that a builder or home buyer takes out to construct a new home or building. This type of financing can also be used by borrowers looking to finance restoration or historic preservation projects. The loan term length is usually between 12 to 18 months, and a long-term loan will need to be sought to include the remainder of the balance. A construction loan also comes with higher interest rates due to the high-risk nature of the endeavor. 

These loans are beneficial because the funds are typically distributed to the borrower in chunks. The funds are intended to be used to pay for building materials and labor. Additionally, you can use the loan to pay for the lot being built on, unless a separate loan is obtained to pay for the lot. 

These smaller chunks over time instead of the lump sum upfront help the borrower only pay interest on the amount borrowed at a given time. These phases of financing and construction keep the builders focused and on track. The loan length is determined on a case-by-case basis, and the approval of the loan sometimes hinges on whether the borrower has a checking or savings account with them.

What is a Construction-only loan?

Much like it sounds, this loan covers the cost of building the home only and is a 12-month short-term loan. Considered high-risk loans, you will have to have all of your ducks in a row and be ready to work for approval. Once the house is built, the builder or buyer has a couple of options for turning the short-term loan into a long-term loan: 

  1. They could refinance the construction loan and turn it into a typical mortgage.
  2. Or, they could get a new loan with longer terms to pay off the first construction loan in addition to the mortgage.

What is a construction-to-permanent loan?

During construction, the borrower makes payments on interest only. A construction-to-permanent loan occurs when money is borrowed for the building, and then the balance of the loan gets converted by the lender into a permanent loan once construction is complete. These loans can be pretty expensive, and we recommend that you only choose a loan that you have compared to other loan programs and that is right for you.

The steps involved in turning a construction loan into a permanent loan typically start with getting the blueprints and builder selected turned over to the lending institution for review. Once approved, construction begins and the lender provides the borrower or building contractor with installments of the loan in different stages throughout construction. Once the building is completed, the borrower usually gets the loan converted into a mortgage, and both loans get rolled into one.

What is a Renovation loan?

A fixer-upper isn’t everyone’s dream scenario, but you may be one of the brave few who enjoys a challenge. For example, if you have found the house you want to purchase but it needs a fair amount of improvements, a renovation loan might be right for you. You can buy the home and pay for the renovations under this kind of loan. 

The loan amount is determined by the lender estimating the after-renovation value. It is also the only type of loan that gives the buyer the future home’s value. Since there are multiple types of renovation loans, you should speak to a loan specialist about which one best suits your needs.

What is an Owner-builder loan?

 If a borrower plans on acting as the contractor or builder, it’s unlikely they’ll qualify for the construction loan. Alternative financing for this kind of borrower is an owner-builder construction loan which is also extremely difficult to obtain. In this scenario, the borrower/builder will have to provide the lender with detailed construction plans and demonstrate the knowledge and capability to take on such a project.

What are the borrowing requirements for a construction loan?

Borrowers will need to be prepared for higher interest rates and put forward a 20%-30% down payment for the loan. If applicable, you may use the equity in the land you own to pay the down payment for the loan. 

The borrower will also need established credit, or else the construction loan may be even more challenging to obtain. The lender will require that the borrower provide the details of the construction. The borrower must prove they’re using a qualified builder or contractor in addition to their credit report and financial information. 

End loan

Basically, a traditional mortgage, an end loan can be applied for once the construction has been completed. An end loan occurs when a construction loan has been repaid upon building completion, and a mortgage is applied for. Often, the construction loan balance gets rolled into the new mortgage loan. Usually, a builder or contractor takes out the construction loan and pays back the loan. Many institutions prefer to lend to both the contractor and the buyer as the end-financer.

What is the interest rate?

Sometimes the construction loan requires that the entirety of the loan be paid off by the time construction is finished. Occasionally, the borrower might only have to pay the loan’s interest while the home is under construction. 

Most commonly, the lender prefers to provide the funds to a contractor over other borrowers. The interest rate for construction lending is typically 1% higher than a typical mortgage. Typically these loans come with an interest rate within a 3.8%-6.5% range. Each loan rate will vary depending on if the loan’s for construction or for construction to a permanent. 

What banks offer construction loans? reveals that Regional banks and Credit Unions offer these kinds of programs and that “Local banks tend to be familiar with the housing market in their area and are more comfortable making home construction loans to borrowers in their community.” Why are construction loans so difficult to get approved for? Well, when the bank loans money for this kind of project, they are taking on more risk. It means more risk because there is no collateral or an asset to ensure the loan’s security. 

Blueprint for success

You’re a visionary with a dream of what your house can be. Nothing worthwhile is easy, so don’t lose focus on the end goal. Especially if this is the direction you want to go. Find a great contractor/builder for the project because they will be the glue holding the endeavor together and making sure each stage is completed correctly and on time. 

Unless you are a builder or contractor for a living, it is best to leave construction to the experts. You will save yourself the trouble and a lot of time handing over the project to someone with experience.

Whether you’re having the house built and designed for you, a building contractor, or acting as both homeowner and builder, you’ll know what options you have. 

To qualify for one of these loans, you will need to be prepared to put in the work. You’ll need to present yourself as an excellent investment to your potential lender. To start with, speak to your bank or lender about your options and the best fit for you. You will be so happy when you enter your newly built dream house once it is completed. So, try to enjoy the journey along the way!


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