Building Dreams: A Guide to Understanding Construction Loans

Reviewing construction plans
Sep 26 2023

Building Dreams: A Guide to Understanding Construction Loans

Dreaming of building your own home? Then you might be wondering how to finance such a project, right? 

Buying an existing property is one thing, but constructing a new one from scratch is quite another. 

To do this, you’ll need a special type of loan that covers the costs of land, labor, materials, and permits. This is called a construction loan and differs from a regular mortgage in many ways.

So, let’s put it under the microscope and find out just how construction loans work. 

 What Is a Construction Loan?

A construction loan is a short-term loan that covers only the costs of building a home or another real estate project. 

Unlike a mortgage paid in one lump sum at closing, a construction loan is disbursed in stages as the project progresses. 

How do construction loans work?

The construction loan process generally follows these steps:

  1. You apply for a construction loan, submitting financial documents, plans, and project timelines.
  2. If approved, you can start drawing funds in installments as the work progresses, typically only repaying interest.
  3. Throughout construction, an appraiser or inspector assesses the build at key intervals to authorize more funds.
  4. Once construction finishes, you repay the loan or convert it to a permanent mortgage and repay both principal and interest.

The amount of money you can borrow depends on several factors, such as your credit score, income, debt-to-income ratio, and the house’s estimated value after construction. 

Generally speaking, you will need a higher credit score and a lower debt-to-income ratio to qualify for a construction loan than a mortgage.

The lender will review your plans and specifications to ensure they meet the local codes and standards.

One of the main advantages of a construction loan is that you only pay interest on the money you use during construction. This means you can save money on interest payments while your house is being built. 

However, this also means that your interest rate will be higher than a conventional mortgage rate as the lender takes on more risk.

Another benefit of a construction loan is that you can customize it to suit your needs and preferences. For example, you can choose between a one-time or two-time close option.

 One-time close vs. two-time close

The one-time close

A one-time close construction loan is also known as a construction-to-permanent loan. This means you only have to apply and close once for the construction and permanent financing. 

Once your house is completed, your loan automatically converts into a mortgage with the same interest rate and terms agreed upon initially.

The two-time close 

A two-time close construction loan is also known as a standalone construction loan. This means you have to apply and close twice: once for the construction financing and once for the permanent financing. 

Once your house is completed, you must apply for a mortgage to repay your construction loan. This lets you shop for the best mortgage rate and terms after construction.

The comparison

Both options have their pros and cons. 

one-time close construction loan can save you time and money on closing costs and fees and lock in your interest rate from the start. 

However, it can also limit your options if interest rates drop, or you want to change your loan terms after construction.

two-time close construction loan can give you more freedom to choose your mortgage lender and terms after construction. 

But it can also expose you to higher interest rates, closing costs, and more paperwork and hassle.

What are the requirements and rates for a construction loan?

Getting approval for a construction loan can be more difficult than a mortgage. Lenders consider construction loans riskier than mortgages. After all, there is no collateral until the house is finished.

To qualify for a construction loan, you will need to meet certain requirements, such as:

  • A credit score of at least 680
  • A debt-to-income ratio of no more than 43%
  • A down payment of at least 20% of the total cost
  • A detailed budget and timeline for your project
  • A reputable builder or contractor with experience and references
  • A comprehensive appraisal and inspection of your plans and specifications

The interest rate for a construction loan will vary depending on several factors, such as:

  • Your credit score and history
  • Your income and debt-to-income ratio
  • The size and duration of your loan
  • The type and location of your project
  • The market conditions and trends

How does a construction loan differ from a mortgage?

A construction loan and a mortgage are both types of loans that can be used to finance a house. However, they have some key differences that you should be aware of before applying for either one.

A construction loan: 

  • Is a short-term, high-interest loan that provides the funds needed to cover the costs of building or renovating a house. 
  • Is based on the expected value of the house after construction.
  • Is disbursed in installments as the work progresses.
  • Requires only interest payments during construction.
  • Has a higher interest rate than a mortgage.
  • Can be converted into a mortgage after construction.

A mortgage: 

  • Is a long-term, low-interest loan that provides the funds needed to purchase or refinance a house.
  • Is based on the house’s appraised value at the time of purchase or refinance.
  • Is disbursed in a lump sum at closing.
  • Requires both principal and interest payments from the start.
  • Has a lower interest rate than a construction loan.
  • Cannot be converted into a construction loan after purchase or refinance.

Why choose CVF Credit Union for your construction loan?

If you are looking for a reliable and affordable construction loan or mortgage, consider CVF Credit Union your financial partner. 

We offer competitive and flexible loans for our members and other products and services that can improve your life.

Some of the benefits of choosing CVF: 

  • You can enjoy low-interest rates and fees, as well as personalized service and guidance from our experienced loan officers.
  • You can access our convenient and secure digital banking tools, such as online banking, mobile banking, bill pay, and e-statements.
  • You can use our other products and services, such as savings accounts, checking accounts, credit cards, auto loans, home equity loans, and more.

Contact us today to start making your dream home a reality.

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