Construction Mortgage Definition

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Construction Mortgage Definition

What Is a Construction Mortgage?

A particular sort of loan for funding the construction of a house is called a construction mortgage. During the construction stage, the borrowing funds are often progressively increased as work advances. Usually, the mortgage only demands interest payments throughout the building phase. The loan balance is payable after the building phase is over, however some construction mortgages may convert to conventional mortgages.

Key Takeaways

  • A construction mortgage is a loan used to finance the construction of a new house.
  • The majority of these loans are interest-only throughout the construction phase and will make payments to the borrower in small amounts as the project develops.
  • Stand-alone construction and construction-to-permanent mortgages are the two most common forms of construction loans.
  • The latter will change to a typical mortgage once the house is constructed, whilst the former are often only available for a one-year period.
  • Construction mortgages may be more difficult to get and have higher rates than standard house mortgages since building a new home is riskier than purchasing an existing one.

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How a Construction Mortgage Works

A construction mortgage, also known as a construction loan, is necessary if you are starting from scratch and want to build a home instead of purchasing an existing one.

Unexpected expenditures often occur in the course of building, raising total costs. To better assure that the majority—if not all—of the building expenditures are paid for on time and avoid delays in the home’s construction, construction mortgages may be obtained.

Construction mortgages may be more difficult to get and have higher rates than standard house mortgages since building a new home is riskier than purchasing an existing one. Nevertheless, there are several lenders out today, including conventional banks and mortgage experts.

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To entice consumers, lenders may provide several choices for construction mortgages. For construction-to-permanent loans, they could also provide locked-in interest rates when building starts. This might include interest-only payments throughout the construction period.

Construction-to-Permanent vs. Stand-Alone Construction Loans

Stand-alone construction loans and construction-to-permanent loans are the two most common types of construction mortgages.

When a building is finished, a construction loan that converts to a permanent mortgage is known as a construction-to-permanent loan. The financing option technically consists of two components: a loan to pay building expenses and a mortgage on the completed house. The benefit of such arrangements is that there will be just one loan closing and one application need.

If a construction-to-permanent loan is not obtained, the borrower may employ a stand-alone construction loan, which normally has a one-year maximum duration. The down payment for such a construction mortgage could be lower. An independent construction mortgage does not allow for interest rate locking. A construction-to-permanent loan’s base interest rates might potentially be greater than the latter.

The construction mortgage obligation, which would become due when it was finished, may require the borrower to apply for a different mortgage. While the new house is being built, the borrower has the option of selling their current home and moving into a rental or another sort of accommodation. Thus, the construction mortgage would be the only outstanding debt and they could utilize the equity from the sale of their existing home to pay for any expenses incurred after the building of the new home.

A stand-alone construction loan may require the borrower to make bigger monthly payments if interest rates change while the project is being built.

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How to Apply for a Construction Loan

Similar to applying for a mortgage, a construction loan application involves an assessment of the borrower’s assets, liabilities, and income. (Therefore, be prepared to provide W-2s, tax returns, financial statements, and credit reports.) But there’s more to it.

The borrower must also have a written purchase or construction agreement in place with the builder or developer in order to be eligible for a construction mortgage. The general project timeframe (including the start and planned completion dates) and the total contract price, which covers all anticipated construction expenses as well as, if relevant, the cost of the land or property itself, should be included in this agreement. Typical components of the package include architectural drawings, thorough floor plans, an analysis of the construction materials, and an extensive list that helps account for the budget.

Financial papers, as well as proof of your building contractor’s or construction company’s current license and insurance, are required.

Most lenders want at least a 20% down payment for a construction mortgage, while some go as high as 25%. The standards for many traditional mortgages are similar to that. But lenders are often concerned with your liquidity in addition to your creditworthiness. They can anticipate having a specific sum of money put aside in case construction expenses turn out to be more than anticipated. Additionally, keep in mind that a stand-alone construction loan is only good for one year, so you’ll need to be prepared to pay it back or be able to get fresh financing by the time it expires.

What Is a Construction Loan?

A builder or homeowner might get a brief loan called a construction loan or construction mortgage to pay for the building of a new house. Instead of being delivered all at once, the payments are sent at predetermined intervals to account for the actual building duration. When the project is done, certain construction loans, which typically last no more than 12 months, automatically convert to ordinary mortgages. However, some construction loans simply expire, necessitating refinancing to become regular mortgages.

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What Are Construction Loan Interest Rates?

Although some loans allow the rate to be fixed for a certain length of time, construction loan interest rates change often along with prime interest rates. In spite of this, construction loans are often thought to be riskier than standard house mortgage loans since there isn’t an existing home to utilize as collateral in the event that the borrower fails. Whether you have a stand-alone construction loan or a construction-to-permanent loan, the interest rate ranges will vary. In general, these loans cost at least 1%—and sometimes 4.5% to 5%—more than standard mortgage rates.

Is It Harder to Get a Construction Loan?

Yes, getting a construction loan is more difficult than getting a conventional mortgage. The contractor or builder is also required to give financial information in addition to the borrower. They must also present a signed copy of the construction contract along with a thorough inventory of the work’s specifics, a realistic budget, and a timeframe for the project. For construction loans, some lenders have stricter creditworthiness requirements as well as greater down payments.

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