How Do Home Construction Loans Work?
Considering a construction loan to finance your new home build? We'll break down the basics of home construction loans so you know what to expect. We will also discuss the construction loan process at Groundfloor.
Construction loans are typically short-term loans with variable interest rates. They're typically used to finance the building of a new home and are paid off when the home is completed. Because construction loans are more complicated than other types of loans, they often require a larger down payment — usually 20% of the total loan amount in a normal setting. The Groundfloor way is different to get home loans.
There are two main types of construction loans
A construction-to-permanent loan finances the building of your new home and converts to a traditional mortgage once construction is complete. With this type of loan, you only have to qualify for one closing and pay one set of closing costs.
A standalone construction loan finances the building of your new home but does not convert to a traditional mortgage. You'll need to refinance the loan into a mortgage once construction is complete. With this type of loan, you'll have two closings: one to close on the construction loan and one to refinance the construction loan into a mortgage. You'll also pay two sets of closing costs.
Government-backed loans such as an FHA 203(k) or VA Renovation Loan may be an option if you're rehabbing an existing property or building a new home from scratch on undeveloped land. These types of loans allow you to finance both the purchase price of the property and the cost of renovations or repairs in one loan. The drawback is that these types of loans can be more difficult (and time consuming) to qualify for than other types of financing.
There are also portfolio lenders who specialize in construction financing and may be willing to work with you even if you don't fit their typical borrower profile (e.g., low credit score, high debt-to-income ratio, etc.). However, these types of lenders typically charge higher interest rates and fees than traditional lenders so be sure to compare your options before moving forward.
Lastly, some builders offer in-house financing which may be an option if you're working with a smaller builder who doesn't have access to traditional lending sources or if you're otherwise having trouble qualifying for a construction loan from another lender. These types of arrangements can be beneficial because they simplify the financing process but they also put you at risk if the builder encounters financial difficulties during construction since you would still be obligated to make your payments even if they can't make theirs. As with any type of financing, it's important to understand all the terms and conditions before moving forward.
There's a lot to think about when deciding whether or not to finance your new home build.
How Groundfloor is Different
We sat down with our Lending and Risk Management team to chat about why we decided to enter the new construction arena, how these loans are structured, and what value they bring to all of our customers.
Q: First thing's first: Why a new home construction loan?
New construction loans are a natural extension of our existing product line. For some time now, we have noticed a strong demand for loans to fund new construction projects in the residential real estate field. Whether it was from folks writing in to us on Facebook or calling our borrower team, it's been made very clear that our audience is looking for this product.
And this makes sense from a financial standpoint as well. With the current state of the real estate market, profitable buying opportunities for fix-and-flip projects are becoming more and more limited. As a result, in order to maintain acceptable profit margins, renovators are turning to larger-scale renovation projects, and thus to higher price point exits. At some point, it simply makes more sense to start from scratch with new construction.
Moreover, data from studies of housing supply and demand over the past few decades indicates that housing demand has outstripped housing supply. After lagging behind long-term averages through the recession in the late 2000s, housing supply is finally beginning to trend upwards again to meet demand. This indicates that a new construction loan program is timely, has ample runway, and has an excellent foundation for release.
Finally, the current market for these types of loans is wide open — for the most part, builders have to turn to banks or larger non-bank lenders in order to receive loans for their new construction projects. True to our mission of creating a radically open, decentralized, and accessible capital market, we saw an opportunity for Groundfloor to step in and change the game.
Q: Why was North Carolina chosen to host the new construction loan pilot?
Update: This is now available to all states that we currently lend in.
In short, because we had a connection there. We partnered with Professional Building Supply, a long-established and highly reputable building supply company, to identify builders who would be good candidates for our new construction loans. As one of the top five building supply vendors in the country with a vast network of experienced builders, they were a natural referral source for us, and they greatly facilitated our entrance into the market.
Additionally, the market conditions in the Raleigh area make it an ideal location for this project — with a growing local economy, several prominent universities, and a burgeoning technology and job scene, Raleigh and its surrounding suburbs provide a perfect place to test out our new construction loan program.
Pending the successful completion of our pilot program, we will begin offering new construction loans in the southeast region first (specifically in Florida, North Carolina, and Georgia), with the intention of scaling the program into different states and regions in the future.
Q: How are these new construction loans structured?
Our new construction loans operate slightly differently than our renovation loans. Borrowers must have new construction experience to be eligible, and they are classified into tiers based upon their experience. The loans fund different percentages of the construction based upon the tier in which the borrower falls.
Once a loan is approved, the borrower is able to access the full amount of the loan in a series of draws. Interest accrues on the loan as it is used. As with our traditional fix-and-flip loans, the borrower may choose to defer monthly payments in favor of a balloon payment at the end of the loan's life.
The investor has a slightly different experience as well. Rather than investing in the loan as a whole, investors can choose to invest in a specific draw of the new construction loan. Regardless of the draw you invest in, each investment will be in the first lien position and will share returns on a pari passu (pro rata) basis. All investments in a particular new construction loan will yield the same interest rate across all draws.
Q: What is the advantage of investing in new construction loans?
As is the case with all loans we offer, rates are risk-adjusted based on the creditworthiness of the borrower and value of the collateral relative to the loan balance. In general, we have found that borrowers who take out a new construction loan are more experienced and have a greater financial capacity than a typical renovator. Furthermore, new construction overall is less risky than a renovation because it is essentially a clean slate — often with renovation projects, you run into issues that you were not expecting, whereas with new construction, you are more aware of all contingencies because you are starting from the ground up.
Additionally, given fairly equivalent properties, the demand for new construction may exceed that for a renovated property. Accordingly, there may be more support for new construction in a falling or flat market. As a result, new constructions may be more able to adjust to changing market conditions.
With more entry points, a different market position and a new borrower segment, new construction loans provide a great way to help diversify your Groundfloor portfolio.
More about the construction phase on the loan
The Construction Process
Before you can apply for a home construction loan, you need to have your plans drawn up by an architect or home designer. Once you have your plans, you’ll need to find a builder who is willing to take on your project. Once you’ve found a builder, they will provide you with a construction schedule and cost breakdown which details how much each stage of the build will cost. This is what you will use to apply for your loan.
Applying for a Home Construction Loan
When you apply for a home construction loan, the lender or Groundfloor will assess both your personal finances and the estimated costs of the build. They will then give you a loan amount which is usually based on the lesser of the two figures. The interest rate on a home construction loan is usually higher than a standard mortgage because there is more risk involved for the lender. This is because if something goes wrong during the build and the house isn’t completed, they could end up making a loss on their investment.
Drawdowns and Progress Payments
Once your loan has been approved, the lender will release funds to your builder in what are known as “drawdowns” or “progress payments”. This usually happens after each stage of the build has been completed and signed off by an inspector. The inspector will make sure that all the work meets building code requirements before releasing funds for the next stage of construction.
What are the eligibility requirements for a home construction loan?
There are several things you will need in order to qualify for a home construction loan:
A strong credit score: in order to qualify for a home construction loan, you will need to have a strong credit score. Lenders will use your credit score as one of the main factors in determining whether or not you qualify for the loan. If your credit score is on the lower end, you may still be able to qualify for a loan, but you may need to put down a larger down payment.
Proof of income and employment. When applying for any type of loan, lenders will want to see proof of your income and employment status. For a home construction loan, this is no different. Be prepared to show pay stubs, tax returns, and other documentation that proves your employment status and income level.
A detailed description of your proposed project. Before approving any loan, lenders will want to know exactly what the money is being borrowed for. When applying for a home construction loan, you will need to provide detailed plans and specifications for your proposed project. This will give the lender an idea of how much the project will cost and how long it will take to complete.
Equity in your property. Most lenders will require that you have some equity in your property before they approve a home construction loan. Equity simply refers to the portion of your property that you own outright— without any debt attached to it. The amount of equity required varies from lender to lender, but typically ranges from 10–20%.
A down payment. In addition to equity, most lenders will also require that you make a down payment on your loan. The size of your down payment will vary depending on the cost of your project and the terms of your loan, but can be as little as 3%.
Documentation of expenses. Finally, before approving your loan, lenders will want to see documentation of all estimated expenses associated with your project (e.g., materials, labor costs, etc.). This helps them determine how much money you actually need to borrow and gives them an idea of what your project timeline looks like.
Mortgage insurance. Depending on the lender and the amount being borrowed, you may also be required to purchase mortgage insurance — especially if you are putting down less than 20% equity. Mortgage insurance protects the lender in case you default on your loan. The premium is typically paid monthly along with your mortgage payments. However, if you have at least 20% equity in your property, most lenders won’t require mortgage insurance.
A good relationship with your builder. While not always required, having a good relationship with your builder can go a long way in helping you qualify for a home construction loan. This is because lenders often view builders with established track records as less risky than those who are just starting out. If possible, try to find a builder who has experience building homes similar to yours and who has a good reputation in the industry.
Experience in building/remodeling homes. If you don’t have experience building or remodeling homes yourself, it may be difficult to get approved for a home construction loan. This is because lenders see borrowers with experience as less risky than those who don’t have any experience. If possible, try to get some experience by working with an experienced builder or remodeler on smaller projects before applying for a home construction loan.
We hope this gives you a good overview of our new construction loans. As always, please feel free to reach out to us at support@groundfloor.us if you have any further questions.
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