Building your Future with Construction Loans

Building a home is an exciting prospect. You can build something that's truly customized to your tastes and needs. However, when it comes to financing your project, many of us don't know much about home construction loans. We talked with Nicole Williamson of Merchants Bank to demystify the process and learn more about the choices and pitfalls of financing your new home build.

Home Mortgage vs. Construction Loan

Most people generally understand what a mortgage is--a long-term loan used to purchase a house. It's easy to imagine that a construction loan is just a mortgage that happens to be used for construction.

In reality, a construction loan is a short-term loan which just covers the duration of a construction project. When the construction is completed, the construction loan is generally converted into a mortgage on the newly built home.

Put another way, a mortgage is a loan on a finished house, whereas a construction loan is a loan on a house in progress.

Builder Financing

Some builders offer their own financing instead of having the homebuyer go out to get their own construction loan. In this case, the builder handles the financing on their end, with the exact details varying from builder to builder. The homeowner still gets to customize the build and buys the home thorough the traditional mortgage process at the end.

It's a good idea to ask your builder if they prefer you to get a construction loan on your own, or if they prefer to finance it themselves.

Applying for a Construction Loan

Just like with a mortgage, you should contact your bank to get preapproved for a construction loan before trying to secure a lot or get plans made.

Once you're ready to apply for a construction loan, you'll go through the underwriting process. Part of this process is similar to what you would go through for any loan. However, banks will also want to see some additional details about your home project.

Every bank's requirements will be slightly different, but most banks will want to see your plans, specs, and a floor and construction statement from your builder (which lists what will be done, who will do it, and how much it will cost). The bank will review these things to make sure the home you want to build is worth the amount you want to borrow.

The bank will also review the land you want to build on. They'll want to make sure that no work has been done on the land (we'll talk more about that when we share a few pitfalls).

Once the construction loan has been approved, construction can begin!

Managing a Construction Loan

Unlike with a mortgage, the funds for a construction loan usually aren't paid out all at once. They're held by a bank or a title company in a special account called an escrow account.

Throughout the process of construction, the builder will submit invoices so they can be paid for their ongoing work. Generally speaking, the bank will review expenses to make sure that the spending is on track for the original plans they received. The bank or title company will also make sure that you approve each payment as well. This is generally a fairly quick process, but it does mean that there will likely be a little bit of paperwork for you to do every week during construction.

Once the home is finished, the bank sends an appraiser to check out the completed home and make sure everything is done. (In some cases, landscaping or other seasonal items might not be finished until later--if that happens, the bank will keep some money in the escrow account to pay for that.) When the work has been completed, the final amount spent will be converted into a regular mortgage loan.

Pitfalls

Williamson shared a few tips for common pitfalls she sees with construction loan borrowers. First of all, it's virtually guaranteed that unexpected items will come up during home construction. It's important to plan for that and to make sure that your construction loan has room for the unexpected. "It's preparing the customer throughout it to make sure that they have those reserves, that we have a backup plan, we have ability to increase the loan amount or some sort of plan so that they're not stuck in a situation where they have these overages that they can't afford," explained Williamson.

Second, it's very important that people not do any work on the lot before the construction loan is approved. Even work that you perform yourself can be a problem, so it's best to leave a lot alone until your construction loan has been approved and you're ready to properly break ground.

Wrapping Up

This is a general introduction to construction loans, but every bank has their own process. If you're thinking about building the home of your dreams, contact one of our member bankers to get started. You should also be sure to check out our Fall Showcase of Homes, where you can meet builders and preview their work in person.