Construction loan types
There are two common types of construction loans.
- Standalone construction loans, or construction-only loans, pay the builder's invoices while construction is in process. Usually, the borrower must repay the debt once the work is complete or within 18 months. The payoff can be in cash or by way of refinancing. A standalone construction loan is a good option for property owners who plan on selling once the project is finished.
- Construction-to-permanent loans automatically convert into a fixed-rate mortgage when construction ends. This streamlines the process for borrowers because there is no loan closing or payoff to manage. A converting construction loan is preferred when the borrower intends to live in or use the newly built structure.
Qualification requirements and process
FHA construction loans, which are financed by the Federal Housing Administration, specify these requirements:
- Downpayment of 3.5% to 10%.
- Credit score of 500 or higher.
- Debt-to-income ratio below 43%.
Uninsured loans will require a higher down payment -- usually 20% or 25% -- and a higher credit score. However, an uninsured loan may offer more flexibility in the amount available. The FHA caps construction loan amounts based on regional housing costs. These loan amount limits can range from about $470,000 to over $1 million.
Borrowers can quantify the funding available to them by requesting a pre-approval letter. The pre-approval will include downpayment requirements, loan amount, interest rate, and loan term, all of which are subject to change before the loan funds.
With a pre-approval in hand, borrowers can collaborate with their builder to solidify their budget and construction plans. Documents required before loan closing usually include:
- Loan application. The application documents the borrower's income and assets. The borrower may need to provide W-2s, tax returns, and bank statements.
- Copy of construction contract. The contract should detail the scope and the builder's responsibilities.
- Cost estimate and timeline for the project. The builder's estimate justifies the loan amount.
- Building plans and specifications. Plans should be complete and support the cost estimate.
- Business documents from the contractor. The lender will require proof of insurance, licensing, and financial solvency from the builder.
Once the loan closes, the contractor works with the lender to satisfy the invoicing requirements. Usually, inspections are required to ensure work progress before funds are released.
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