What is a home construction loan and how to get one.
Financing the construction of a new home differs from that of buying an existing home, and can be a more rigorous process for the home-building client.
Lenders will request more information, and often require more money up front. That said, there are a couple of options available for clients building their own home, giving clients the ability to choose an option that best suits their financial needs.
Financing Differs Between Countries
Financing a new home looks very similar in Canada and the US. The variations in finance-specific terms should be noted, and subtle differences in loan timelines and conversions, but in general financing a home in both countries follows the same set of guidelines.
In Canada, clients have the option to build using either a “Process-Draw” mortgage, a “Completion” mortgage, or a combination of the two. With Process-Draw mortgages, clients apply for a loan which carries them through the building process – these loans are disbursed at stages during construction, with each stage having to pass inspection before the next payment is granted.
Completion mortgages require a signed contract and potentially a small down payment, but these types of loans only require full payment when a home is completed. Often a client will start with a Process-Draw mortgage which is then converted to a Completion mortgage once the building stage is finished.
Similarly, in the US the actual construction process is financed through what is known as a home construction loan. These loans are typically short-term (most often covering up to 12 months of building) and typically have a higher interest rate than a standard mortgage. Clients typically only have to pay the interest on the loan during construction.
Construction loans can be either be used throughout the duration of the building process and then converted to a Long-Term mortgage, or a client can opt for a combined Construction loan and Long-Term mortgage package known as a “Construction-to-Permanent” loan.
We can think of it this way – Process-Draw and Construction are two ways of describing the same type of loan, as are Completion and Long-Term/Permanent.
How to Obtain a Loan
While you’re in the initial phases of planning to build a custom home, it can be useful to talk to a lender about financing; you’ll get a better sense of what a realistic budget looks like for your home, and can also get pre-qualified and/or pre-approved for a home construction loan. Your lot (if you already have one) can be used as equity, as can other real estate that you currently own. The most important information lenders will look for is whether or not you have the ability to pay back the loan.
After you’ve worked out your building plans, timeframe and cost estimate with your builder, you can approach a lender to apply for a loan. Very often credit unions and regional banks are more likely to grant a home construction loan, with some larger builders also offering finance packages. The application process is rigorous, with lenders requiring details such as proof of income, credit history, and a record of your assets. By reviewing all of these financial details, lenders are able to determine whether or not you are an attractive customer.
Once all of your information has been verified and complied with the lender’s requirements, the lender will require finalized house plans, a signed contract between you and your builder, and often an appraisal of the projected value of your new home in order to authorize and approve the Process-Draw/Construction loan.
Even though the construction loan has been approved, neither clients nor builders will have access to the lump sum. Payments from the process-draw/construction loan are paid in disbursements accompanied by inspections during construction – this is called the “draw process”. Inspections ensure the project is staying on time, and can increase efficiency at the job site. The next disbursement will not be paid until the work of the previous payment has been completed.
Once construction has concluded, if you opted for a separate short-term construction loan, there are three final boxes to tick before the construction loan can be transitioned to a long-term mortgage: passing a final inspection, obtaining a “certificate of occupancy”, and getting signed confirmation that contractors/builders have been paid in full. When the lender has received verification of these three items, the home construction loan can be converted to a long-term, fixed-rate mortgage with any unused funds from the construction loan being contributed to the mortgage.
Things to keep in mind
– It is preferable to secure a loan with only one closing cost, typically in the form of a construction-to-permanent loan
– Sometimes builders will take on the construction loan instead of the client – this can be a factor in choosing a builder
– Arrangements can be made in the contract for the builder to assume responsibility for payments if the construction process runs over schedule – this scenario can be helpful for getting the building finished on time, and can provide significant savings considering how frequently the construction process takes longer than expected.
While financing new home construction can be more intensive than securing a mortgage on an existing home, making sure you’re prepared for and knowledgeable about all stages of the process will help put you in the best position to finance your dream home.