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How to Decide Between Home Construction Loans and Typical Mortgages?

Most prospective homeowners are constantly keeping an eye out for their dream home, the one that checks all the boxes. But some buyers prefer to start from scratch by building their dream home with a home construction loan.

Home construction loans are distinctly different from typical mortgages. They give buyers the option to include everything they want in their home, but they’re often significantly more complicated. Learn about the primary differences between home construction loans and typical mortgages before deciding which is the right option for you.

What are the differences between a home construction loan and a traditional mortgage?

There are several key differences between home construction loans and traditional mortgages. For one, when you borrow the money to build a house, the loan is unsecured, meaning the loan isn’t backed by any collateral since the house isn’t yet built, as opposed to traditional mortgages.

Since lending institutions are assuming greater risk, they are generally more hesitant to approve these types of loans. To be a strong candidate for a home construction loan, buyers need good to excellent credit scores, a stable income and a low debt-to-income ratio. Lenders also generally require 20% or more in down payments. This is quite restrictive for most buyers, especially compared to traditional mortgages, which offer down payments as low as 3.5%.

Depending on the type of home construction loan you choose, you could also be required to obtain multiple loans, which can mean paying closing costs more than once. Closing on a construction loan can also take a little longer since the process involves another party — the builder.

Which type of home construction loan should I choose?

The two most common types of home construction loans are construction-to-permanent loans and construction-only loans. Choosing between these two loans depends on several factors.

For most prospective buyers, a construction-to-permanent loan is the most convenient option. This type of home construction loan covers costs to build the house and rolls them into a standard mortgage, giving buyers an extended period of time to pay off the debt, similar to a traditional mortgage. As with traditional mortgages, buyers generally have the option to choose between 15- and 30-year terms and fixed or adjustable rates. But unlike typical mortgages, these types of home construction loans often require down payments of 20% or higher.

For construction-only loans, buyers are responsible for paying off the entire loan once construction is complete, which is generally a year or less. These types of home construction loans are good options for buyers who have significant savings and can cover large costs. Buyers can also obtain a separate mortgage to cover a construction-only loan once the debt is due. This gives buyers the option to shop for a permanent lender during the building phase but also requires separate applications, which could mean paying closing costs twice.

How to secure a home construction loan

Not all mortgage lenders offer home construction loans, so you’ll need to first identify potential lenders. Next you’ll want to get pre-approved for a loan from at least one of the lenders you’ve identified. Some lenders offer simple online applications for pre-approval. Once you’re pre-approved, work with a builder to design a home that fits your needs and budget.

Although the homebuilding process has more moving parts than purchasing an existing home, the payoff can be worth it. You’ll have a house designed for you from the ground up.

Interested in learning more about home construction loans? Call 1.800.205.3464 to speak to a First Merchants Bank loan expert today.