Construction loans explained

#How a construction loan works

A bank won’t hand you the full loan on day one when the collateral is a vacant lot. Instead, the lender approves a total amount based on your plans, budget and builder, then releases money in draws as each stage of work is finished and inspected. During construction you typically pay interest only on what has been drawn, so payments start small and rise as the house goes up.

When the house is complete, the construction debt has to become a long-term mortgage. How that happens is the main choice you make.

#Single-close vs two-time close

A single-close loan suits most borrowers who want certainty. A two-time close can make sense if you expect rates to fall, need a construction lender that specializes in custom builds, or plan to sell another home to make a large down payment on the permanent loan.

#Fannie Mae’s single-close rules

Many single-close loans are conventional loans written to Fannie Mae’s Selling Guide so they can be sold once the house is finished. Its main rules:

• Fannie Mae buys the loan only after construction is complete and the loan has converted to permanent financing.
• The construction period can’t run longer than 12 months at a time, or 18 months including extensions. No exceptions are granted.
• The permanent loan can have a term of up to 30 years after conversion, not counting the construction period.
• Loan-to-value on a purchase is measured against the lower of the total cost (construction plus the lot’s price) or the home’s “as completed” appraised value. If you already own the lot when the first draw is made, the loan is treated as a limited cash-out refinance and measured against the as-completed value, so equity in the land works like a down payment.
• At conversion, only the rate, loan amount, term and amortization type can change; the amount can rise only for documented cost increases, and the only allowed amortization change is from adjustable to fixed.

Federal ability-to-repay rules exempt a construction phase of 12 months or less, so lenders structure the construction stage as a temporary loan and apply full underwriting to the permanent mortgage.

#Government-backed construction loans

FHA and VA loans can also be used for one-time-close construction-to-permanent financing through lenders that offer it, with the same benefits as on a purchase — low or no down payment and the usual mortgage insurance or VA funding fee, which applies to construction loans at the purchase rates. USDA guaranteed loans can finance building a new home in an eligible rural area too; see USDA loans. Fewer lenders offer these programs, so expect to search harder and to need a builder the lender approves.

#Draws, inspections and interest during the build

Before closing, your builder gives the lender a detailed budget and a draw schedule tied to stages of work. At each stage an inspector confirms the work is done, the title is checked for new liens, and the lender pays the builder or the subcontractors directly.

#How to get a construction loan

1. 1

   Pick the plans, lot and builder

   Lenders review the builder’s license, insurance and track record as well as your finances.

2. 2

   Get approved

   The lender underwrites you and orders an appraisal of the home “as completed” from the plans and specifications.

3. 3

   Close once

   You sign for the construction phase and the permanent mortgage together, and the lot is bought or pledged.

4. 4

   Build in stages

   Each draw follows an inspection; you pay interest on the amount drawn.

5. 5

   Finish and convert

   A final inspection confirms completion, and the loan converts to a regular mortgage with principal-and-interest payments.

Many lenders also expect a larger down payment on construction loans than on an existing home, and some require cash reserves. Compare total costs, including any construction-period fees, on each lender’s Loan Estimate, and check the closing cost estimator for your state.