Construction loans are mortgages offered by lenders to individuals planning to remodel or completely build an inhabitable structure. Unlike standard mortgages, these loans often require much smaller payments for a short period of time while individuals have large labor and materials expenses during construction. Construction loans may take longer to get approved because of the risk inherent in lending against a potential structure, but once approved they offer a great path to homeownership for most borrowers.
Similar to most real estate loans, there is a vigilant documentation process for construction loans. For standard salaried employees (those who receive a paycheck with deductions), the following is required for income verification: two to three years of W2s, at least six consecutive paychecks showing all deductions, three years of tax returns and any additional income documents (leases, 1099s from subcontract work). For self-employed borrowers, lenders will also require three years of schedule Cs (sole proprietors) or three years of S-corp or corporate returns. Self-employed borrowers should also be prepared to show at least two years of bank statements to confirm cash flow.
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Lenders require that construction loan borrowers show proof of land ownership. Sometimes lenders will complete a construction loan mortgage that also involves purchasing a parcel of land -- however, this reduces the chance that a borrower can roll the loan into a traditional repayment loan once construction has finished. Land ownership can be proven with a land title.
Before acquiring a construction loan, borrowers must get estimates from contractors. Lenders will want to know a total dollar amount required for construction, of course, but they'll also require a line-by-line breakdown of what will happen, when it will happen, how much labor will cost on a day-to-day basis and how much materials will cost, as well as a schedule that contains an estimated completion date.
Lenders do not want borrowers to get mixed up with unreliable or unethical contractors that put their investment at risk. Therefore, lenders will require a credit history, a contractor's signature on the project write-up (documenting the work to be done) and a copy of the contractor's license to operate in that particular state. This information is standard, and most contractors will offer the documents when performing estimates.
Construction to Permanent
Most borrowers should consider the construction-to-permanent option when obtaining a loan to build. These loans offer a period of interest-only payments (usually lasting through construction), and then switch to traditional repayment schemes where a borrower must pay principal and interest payments during the course of 10, 15 or 30 years, until the loan is paid in full. This simplifies things for a borrower as it eliminates the need to refinance the construction loan after the building is completed. The requirements for these loans are similar to standard construction loans, but borrowers must be prepared to show enough income to repay a full principal and interest payment after the interest-only period has expired.