Using a Construction Loan to Build Your Dream Home

Retirement has finally arrived, and you've checked all the right boxes. Mortgage paid off, check. Loans to help kids through college paid, check. Nest egg ready for the future, check. You've found a great spot to build your retirement dream home and you're ready to bring your blueprints to life. But there's one step you haven't yet navigated: getting a construction loan to finance the project.

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Sure, you've borrowed from the bank before. But construction loans can be quite a bit more nuanced than traditional mortgages. A common step for borrowers is to start the process by getting pre-qualified for a home construction loan.

Construction Loan Options

There are two primary varieties of construction loans: construction-to-permanent and stand-alone. The distinction is important and there are benefits of each, depending on your financial situation.

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A construction-to-permanent loan, sometimes referred to as a single-close construction loan, converts into a permanent mortgage after the house is built. There is just one closing at the start of construction, so you only pay closing costs once. What's more, you can lock in your interest rate for the lifetime of the loan. Once your build is completed, your lender converts the construction loan into a permanent fixed- or adjustable-rate mortgage.

By contrast, a stand-alone construction loan covers just the home build. Once the work is completed, you'll need to secure a separate mortgage to pay off the construction debt, therefore requiring two closings and sets of fees. Another disadvantage of a stand-alone loan is that you can't lock in a mortgage rate. That means you run the risk of rates rising before you are ready for that second loan. However, stand-alone construction loans tend to require lower down payments and do allow borrowers to shop around for a mortgage once their home build is complete.

Both construction-to-permanent and stand-alone loans only require you to make interest payments while your dream house is being built, and it's typically a variable rate during construction. Your lender will pay funds directly to the contractor in installments at various pre-defined benchmarks, known as a "draw schedule." Your lender and your builder will work closely to ensure your project and your payments stay on track.

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Qualifying for a Construction Loan

Even if you have a stellar credit score, it's a good idea to get your ducks in a row before submitting a construction loan application. You'll need to prepare all of the same documents required for securing a traditional mortgage, plus a comprehensive list of the construction details.

Here's a basic checklist of what you may need to supply to your lender as part of your construction loan application:

Current financial statements covering debt, income and asset information.
A signed construction or purchase contract with your builder or developer that includes project plans, specs and budget details.
A timetable for construction that includes start and completion dates.

Your lender will closely review the project plans and contract to ensure your builder's quoted costs are aligned with market costs. They will also consider factors like budget overrun and unanticipated upgrades — as it's not uncommon to splurge on granite countertops once kitchen construction begins. Some lenders may also request financial information from the builder to ensure they will be financially solvent throughout the project.

Getting Started

Because construction loans have higher underwriting standards, many people work with a bank they already have a relationship with. That said, you might want to comparison shop to ensure that your bank's fees and interest rates are competitive. It's important to remember that this will be a long-term relationship, so you should find a knowledgeable loan officer who will take the time to talk through your options, provide personalized guidance based on your financial situation and do due diligence on your contractor's plans.

Building a retirement nest to your own specs requires a bit of legwork, but the result will be enjoyed for years to come. And it means you can whittle one more box off your list: Dream home ready to go, check.

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Disclaimer

This article was written by and presents the views of our contributing adviser, not the Kiplinger editorial staff. You can check adviser records with the SEC or with FINRA.

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Rick Bechtel is EVP, Head of U.S. Residential Lending for TD Bank . With nearly 30 years of industry experience, he is responsible for growing TD Bank's mortgage business and sales force, maintaining the bank's risk appetite and unique focus on the customer, and optimizing best-in-class technology across the business.