Building a custom home gives you the opportunity to choose the location, floor plan, finishes, and features that fit your needs. Financing a home that has not been built yet, however, works differently from obtaining a traditional mortgage on an existing property.
A construction loan can provide the financing needed to purchase land and build a home, depending on the loan program. Understanding how these loans work can help you prepare for the additional planning, documentation, and oversight involved in a custom home project.
What Is a Construction Loan?
A construction loan provides funds to cover eligible costs associated with building or substantially renovating a home. Unlike a traditional purchase mortgage, where funds are generally disbursed at closing, construction funds are typically released in stages as work progresses.
These scheduled payments are commonly called draws. The lender may require inspections or other documentation before releasing funds to the builder at different stages of construction.
Construction-Only vs. Construction-to-Permanent Loans
Construction financing can be structured in different ways. A construction-only loan generally provides temporary financing for the building period. When construction is complete, the borrower typically needs separate permanent mortgage financing to pay off the construction loan.
A construction-to-permanent loan combines construction financing with the permanent mortgage. With an eligible single-closing transaction, the permanent financing is established before construction begins and the loan converts to permanent financing after the home is completed and applicable requirements are satisfied.
How Do Construction Loan Draws Work?
The lender generally does not give the borrower or builder the entire construction budget upfront. Instead, funds are released according to an approved draw schedule tied to progress on the home.
For example, draws may correspond with milestones such as the foundation, framing, mechanical systems, drywall, and final completion. Inspections can help confirm that the required work has been completed before additional funds are released.
What Do Lenders Review for a Construction Loan?
Construction financing requires the lender to evaluate both the borrower and the building project. In addition to reviewing income, assets, debts, and credit, the lender may need detailed plans, specifications, construction contracts, budgets, permits, and information about the builder.
The lender may also evaluate the property's expected value based on the completed home. Requirements vary by lender and loan program, so getting financing lined up before committing to a project is important.
Choosing the Right Builder Matters
Your builder plays an important role in the financing process. Construction lenders may require builders to meet specific licensing, insurance, experience, financial, or approval requirements before funds can be disbursed.
Before signing a construction contract, review the builder's experience, references, licensing, insurance, previous projects, warranties, estimated timeline, and procedures for handling change orders or unexpected costs.
Can Veterans Use a VA Loan to Build a Home?
Eligible Veterans and service members may be able to use a VA-backed loan to build a primary residence. VA construction financing can include the cost of building the home and, in eligible transactions, the land or remaining balance owed on the land.
VA construction loans require a participating lender, and not every VA lender offers them. Eligible borrowers must also satisfy VA and lender requirements for credit, income, occupancy, builder approval, appraisal, and other aspects of the transaction. A VA funding fee may apply unless the borrower qualifies for an exemption.
Plan for Construction Delays and Cost Changes
Even a carefully planned construction project can encounter unexpected expenses or delays. Weather, material availability, labor issues, permitting, inspections, and requested design changes can affect the schedule and final cost.
Before building, understand how your construction contract and loan address cost overruns, contingency reserves, change orders, completion deadlines, and expenses that exceed the approved construction budget.
Is a Construction Loan Right for Your Dream Home?
A construction loan can make it possible to finance a home built around your needs, but the process generally requires more planning than purchasing an existing property. Your financing, builder, plans, budget, appraisal, draw schedule, and construction timeline all need to work together.
Loan Wolf Lending can help Florida homebuyers explore construction and new home financing options and determine which programs may fit their plans. Call 754-755-3075 to discuss financing for your future home.