If you're building a new home or commercial space, a construction loan provides the financial means to complete the project. These are short-term loans that pay for materials and labor during the construction phase. Your lender disperses funds at different intervals to cover construction expenses, and you make interest-only payments during the construction period. Once the contracted builder completes the property, the lender converts your construction loan to a traditional residential or commercial property loan.
Constructions lenders will verify your income before approving your construction loan application. You have to list your annual or monthly income before taxes on the application, as well as supply your most recent tax return and paycheck stub. In you're self-employed, the construction loan lender will usually need your tax returns from the previous two years.
Your credit history and score also factor into the decision. Ample income alone isn't enough to obtain a construction loan. Loan companies have specific credit requirements, and the higher your credit score, the better. You should aim for a credit score of at least 680 or higher if you need a construction loan. The better your credit score is, the better rate and terms you can expect.
You can order your own credit score from Myfico.com. If your credit does not meet a construction lender's minimum requirement, take steps to improve your score. Paying your bills on time and reducing your debt helps add points to your score.
Too many prior outstanding debts can stop a construction loan approval. A review of your credit report by the construction lender will reveal current balances on your credit cards, loans, and other lines of credit. To qualify for a construction loan, your debt-to-income ratio should not exceed 45 percent. This is the percentage of your income that goes toward debt repayment each month. Calculate this ratio by dividing your total debt payments by your gross monthly income. For example, if your debt payments equal $4,500 and you earn $6,000 gross a month, your debt-to-income ratio is 75 percent.
Obtaining a construction loan often requires a hefty cash reserve. You need cash for your down payment, which can range between 20 and 30 percent of the loan balance. Additionally, the lender may require six months of principal, taxes, interest and insurance payments in reserve funds. If you own land with ample equity, you can also use your land equity as down payment on the loan.
Even if you meet the general requirements for a construction loan, the lender will not approve your loan until you provide information specific to the construction process. You can include a land purchase with your construction loan. If you own land, the lender will need a copy of the land deed as proof of ownership. The lender also will need an estimate from the builder that provides a line-by-line breakdown of the construction costs, including labor and materials. Additionally, the lender will need a copy of the contractor's license.
To protect yourself and avoid a shady builder, conduct additional research on the builder. Ask the builder for references, or contact your state attorney general's office or the Better Business Bureau and check for complaints or lawsuits against the builder. When researching references, be sure to follow through and check them out. Unscrupulous builders and contractors can provide seemingly legitimate references, that have been faked, so it's best to do your homework.