How Do Home Building Loans Work?
You’ve purchased your plot of land, chosen the perfect floorplan, and even started thinking about paint colors—but do you know how you’ll finance building your home?
Mortgages vs. Construction Loans
When you buy an existing home, the financing process is onerous but predictable. Assuming you have enough assets and income to cover the monthly payment and a high enough credit score, you can work with most local or national banks and mortgage brokers to acquire a mortgage. And while a 20% downpayment is advisable, with programs like FHA buyers can put down payments as low as 3.5%.
Homebuilding doesn’t quite work like that. If you imagine it from the bank’s point of view, construction is a riskier investment—if you default on a mortgage, the bank can take back the house, while if you default partway through a construction project, they are left in a tougher position. That lack of collateral makes lenders a lot pickier. In addition to a 20-30% down payment, most lenders require a credit score of at least 680 for this type of loan. Interest rates are also typically at least one percentage point higher than a mortgage. But those aren’t the only things to keep in mind when taking on a construction loan.
Key Characteristics of a Construction Loan
Unlike mortgages, which typically have a 15-30 year term, construction loans are intended only to cover the duration of a building project or renovation. To qualify for a construction loan, you’ll likely have to provide documentation of architectural plans and details about your builders—a piece that Atmos will handle if you use our platform. If you’re handling the loan application itself, you can expect more one-on-one work with a loan officer than you’d expect with a mortgage. There are a few other key differences to be aware of, as well.
When you take out a mortgage, the bank pays out the purchase price of the home to the seller in full. Construction loans, on the other hand, are paid directly to the contractor in installments known as “draws,” which are disbursed when each phase of the project is completed to fund the next phase. The contractor does not receive full payment until the building is completed and inspected. Since these terms are a bit complicated, it’s essential to work with carefully vetted contractors. There is one major bonus to a construction loan, though— payments during construction are interest-only until the building process is complete.
Construction Loan vs. Construction-to-Permanent Loan
If you take out a construction-only loan, the balance immediately comes due upon completion of the home. Unless you have a stash of money under your mattress or are anticipating a cash influx from the sale of an existing home, you’ll need to then take on a traditional mortgage for the new home, which you will use to pay off the build over a standard mortgage term. Taking out the construction loan and mortgage separately means you’ll have to pay closing costs twice—and it also means running the risk of the permanent financing falling through, leaving the buyer with a construction loan to pay off immediately.
A construction-to-permanent loan, on the other hand, is structured from the start to convert to a mortgage (with a lower rate) once the building process is complete. Going with this option allows the buyer to save on closing costs and lock in rates from the start, making it a compelling option for builders who plan to finance their homes with a long-term mortgage.
It all sounds complicated—and it can be. But if you work with Atmos to build your home, much of the legwork will be done between us and our partnered lender behind the scenes. We’ll help you not only ensure that your construction loan converts to a mortgage if desired, but also roll in your land loan if you have one to leave you with a simple monthly payment. That time and money savings will leave you with the resources you need to focus on making the new house your home.
Ready to get started? Begin building today!
