After making the exciting decision to build your own new home, you will no doubt next be turning your attention to how your self-build is going to be funded and wanting to find out which finance options are available to you. You may think that a traditional mortgage will help you to build your new home, however, you should be aware that you will not be able to get a traditional mortgage for a construction project. Instead, you will need to find a construction loan to finance your build.

What is a construction loan?

A construction loan is used for the purpose of financing the building or renovation of a home and comes in a few variations. It may come as a bit of a surprise, but you will not be able to secure a traditional mortgage for these kinds of projects, as the completed value of the property cannot be established until the project is finished. Only then can you take out a mortgage on the property.

You will, however, be able to establish an estimated value of the property from the plans using the same pricing systems as buying a completed home. A traditional mortgage lender will assess the value of a loan by looking at the fair market value of the home, which is determined by the home’s condition in comparison to other recent sales. In the same way, a construction loan will use the costs associated with the construction and purchase of the land as well as a provisional projected value of the completed property.

There are three different types of construction loans available on the market currently;

• Construction to Permanent loans: This type of loan for construction is available as long as you have definitive construction plans and timelines in place. The lender will then make payment, in the shape of draws, against completed stages of the construction directly to the builder as the work is finished according to the agreed schedule. When the project has been completed and you have a finished home, the lender will then convert the construction loan into a traditional mortgage. This ensures that you are able to secure the interest rates at the closure of the construction loan, making the repayment structure much more stable.
• Construction Only loans: A construction loan needs to be paid off in full once a building project is completed. A construction loan is a good choice if you either have a lot of money to work with, or are confident that the outstanding balance will be covered by the sale of your previous property. There is also the chance to shop around other lenders to find the best mortgage rates possible to cover the cost of the construction by converting the construction loan to a traditional mortgage. This choice will involve finding approval for the total sum of money for a second time.
• Renovation Construction loans: As the name suggests, this type of loan is for the renovation of an existing home and, as such, the loan itself is for the renovation work to be completed on the property. The mortgage is a separate entity and will encompass the purchase price of the property. The construction loan will finance the renovation work only and will once again need to be paid in full once the project is completed. This means that the borrower will need to find a second mortgage for the sum of the construction work, or have an extension agreed to the mortgage they already have on the property after it is revalued due to the completed renovations.

How construction loans work

A traditional mortgage is paid out by a mortgage lender to cover the cost of a home in one lump sum at closing of the sale. In contrast, a construction loan is paid in installments over the course of the completion of various stages of the construction of the home which are pre-approved at the beginning of the loan’s lifespan. The lender will make payments to the builder as these various stages come to completion and eventually, when the project is complete, the total cost is transferred to the borrower.

Each of the installments paid to the builder are called ‘draws’ and each of these draws will reimburse the builder for the costs incurred by completing each phase of the project. This means that the builder, or you as the borrower, will need to have the cash readily available to cover these costs up front.

Before each of the draws can be paid, the lender will need to inspect the property to verify the cost of the current phase of building, as well as ensure the builder is still in line with their projected timeline.

With the financing of a construction loan being so variable, it is crucial to work with a good builder. You will need someone who is well-versed in budgeting and scheduling as well as having the ability to work well within those limitations.

Another thing to ensure is that you do your research when applying for a loan, so that you end up with a reputable lender.

The benefits of a construction loan

There are a few benefits to choosing a construction loan over a home equity line of credit or other privatised loans;

• Interest-only payments during the construction phases: Since the loan isn’t paid out in full until the new construction is complete, the lender will not ask for you to pay the principal until then either. Making interest-only payments on the loan will allow you more time to save for the future costs of the mortgage after completion.
• Flexible terms: You will generally be able to work your loan terms around your needs for the project, but this will include having a set plan before you apply for finance.
• Added scrutiny provides structure: The added scrutiny of the lender will help to ensure your project stays on budget and on schedule.

The disadvantages of a construction loan

Like anything in life, there are always negatives to take into account;

• They are harder to qualify for: Typically a credit score of 680 is required as well as a 20% down payment towards the loan.
• Higher interest rates: Construction loans typically have variable interest rates which correspond to a certain percentage over the prime rate. For example, if the prime rate is 4% and your loan is prime plus 2%, you will pay 6%.
• Short term loans come with inherent risk: At the end of the loan term, you will need to be able to pay off the loan in full, but this doesn’t really factor in to a construction-to-permanent loan as you will already have finance in place to pay off the full construction loan.