Explore the Mortgage101 Library
Check Local Mortgage Rates
Loan Program Choices
Use our calculator to find out your estimated monthly payment in advance: Enter the loan amount, interest rate, and length of mortgage.
Try our Mortgage Payment Calculator
Construction loans are loans that are made to the consumer for the purpose of building a new home. A construction loan is short-term and converts to a permanent loan once construction is completed. Construction loans are great for the consumer who already owns land; the land can often be used as collateral for the loan.
Borrower’s Ability to Repay Loan
There are several factors that the lender will look at when considering an application for a construction loan. The first is the ability of the borrower to repay the loan. During the construction phase, money is disbursed in what are called “draws,” which are based on the stage of construction completed at certain intervals. The borrower is charged interest based on the amount drawn. In many cases, the borrower is required to set aside a certain amount of money called an interest reserve. Monthly payments are made from this account until the project is completed, although the loan can also be structured in a way that requires the borrower to pay interest monthly, based on the amount drawn.
The borrower will have to show that he will be able to repay the loan once the full amount has been disbursed. The lender will want to see proof of income and the amount of any other outstanding debt. These two amounts will be compared in the debt-to-income ratio, which is found by dividing the fixed monthly expenses by gross monthly income. Most lenders like for this ratio not to exceed 36 percent, although some lenders allow up to 45 percent, depending on the amount to be borrowed. The other ratio that will be considered is the housing ratio, which looks at gross monthly income divided by monthly housing expenses. This ratio generally should not exceed 28 percent. Monthly housing expenses include mortgage payment (interest and principal), real estate taxes, hazard insurance and any other mandatory fees such as homeowner’s dues.
Credit Score and Cash Reserve Requirements
Credit score and cash reserves will also be considered. Credit score requirements will vary depending on the amount of the loan. The higher the loan amount, the higher the credit score will need to be. Most lenders would like to see a cash reserve in the amount of at least six months of PITI (payment, taxes, interest and insurance).
Value of Home
Construction loans are made on a project that has not yet been completed, so the lender bases much of the loan qualification criteria on the value of the finished product. An appraisal will determine the value of the home once it is completed. A loan-to-value (LTV) calculation will be done in order to insure that the lender is covered in the event of non-payment by the borrower. LTV is the percentage of the appraised value of the home minus any mortgage amount. The lower the LTV percentage, the less risk exists for the lender, so loan terms may be more favorable.
Budget for Loan Amount
The loan amount will be based on a budget provided by the borrower, detailing all costs of the project, including plan and permit fees, construction costs and any fees associated with the loan. This budget should be carefully completed because there will be no money available above the loan amount, even if costs exceed the original budget.
- Appraisal Basics
- Should You Refinance? Make Sure the Timing is Right
- What Lenders Don't Reveal About Home Equity Loans
- FHA Loans for a First-Time Home Buyer
- Home Equity Loans for People with Bad Credit
- FHA Eligibility with Bankruptcy and Foreclosure
- What To Do When Mortgages Default
- How to Get Approved for an FHA Loan despite Bad Credit
- 3 Reasons Banks Reject Short Sales