If you want to construct your dream home or take on a major renovation, a construction loan is a necessity to raise the needed funding. Unlike traditional mortgages, these loans have their own set of rules and standards. On that note, here’s what you need to know about construction loan requirements, and how they’re similar to (or different from) a VA loan.
What Is a Construction Loan?
A construction loan is a short-term loan used to finance the building or renovation of a home or other real-estate project. Unlike a regular mortgage, a new build loan won’t transfer you the full amount of the loan all at once. Instead, the loan will be released throughout the build in set stages, usually in the form of ‘draws’ (payments).
Once the home is constructed, the borrower usually rolls the loan into a permanent mortgage. Some refinance, while others take out a construction-to-permanent loan, which involves refinancing one loan for the construction and another for the mortgage once the building is complete.
People Who Might Want to Consider a Construction Loan
Who typically uses construction loans?
- People who build their own homes
- Real estate investors
- Renovating homeowners
These types of loans are perfect for jobs which require a phased cash flow. But if you’re looking at a VA loan vs VA one time close construction loan, a VA loan offers more flexible options that are often better for buying preexisting homes.
Key Construction Loan Requirements
Before lenders approve your application, they’ll consider several factors to make sure your project is feasible and that you’re stable financially.
Good Credit Score
One word of caution is that the minimum you need is a decent credit score. Most lenders will require a minimum score or 680 to qualify for a construction loan. Having a higher score can increase your likelihood of approval and help you get a better interest rate.
VA loans are more forgiving. Lenders sometimes approve applicants with scores as low as 620 for VA loan, so it can be a great option for veterans with only a few years of credit under their belts.
Stable Income and Employment
Lenders need to be confident that you will be able to pay the loan back. Expect to provide:
- Recent pay stubs
- Tax returns (last two years)
- Bank statements
- Evidence of steady employment
Applicants who are self-employed may experience additional scrutiny. As with a VA loan, proof of steady income is also a requirement, but construction loans require greater verification.
Low DTI (Debt-to-Income Ratio)
Your debt-to-income ratio is how lenders determine how much you can afford for normal, recurring expenses. A DTI of 45% is the maximum most lenders require on conventional loans.
This is true in a VA loan vs construction loan situation, but VA loans can be slightly more lenient if you have compensating factors such as a good credit score or cash reserves.
Construction Plan and Timeline
Here is what lenders will want to see in your plan, along with guidance for maximizing its impact.
- Architectural designs or blueprints
- Construction schedule
- Phased budget
- Signed contract with a licensed builder
On a construction loan, it’s got to be detailed and have professional documentation to support it. In comparison, VA loans require only a home inspection and appraisal for existing homes.
Licensed Builder or General Contractor
For most construction loans, you’ll need to find a licensed, bonded contractor who meets the requirements of the lender in question. The builder must provide:
- References and credentials
- Proof of insurance
- A signed building contract
Not many lenders provide owner-builder loans and it is only available to those with professional construction qualifications. New Construction New construction is rarely available with VA loans, unless an VA approved lender is building it to VA standards.
Down Payment
There is typically a 20%–25% minimum down payment requirement for construction loans. Now you have skin in the game, meaning the lender knows you have more to lose by not making payments and further participating in this venture, adding to your credibility, reducing the lender’s risk.
However one of the major variances between a VA loan vs construction loan is that the down payment is required. VA loans make it possible for eligible veterans to purchase homes with 0% down, which is a big deal.
Appraisal Based on Future Value
Because the home does not yet exist, lenders need an “as-completed” appraiser to estimate the future value of the finished property. This forecast value is frequently used as the basis of the loan.
That is not the case with a VA loan; the appraisal reflects the condition of the home and its market value.
Construction Budget and Cost Breakdown
Your budget will be under a microscope by any lender. You’ll need to provide:
- Detailed cost estimates
- Material and labor expenses
- Permit fees
- Builder fees
- Contingency reserve (usually 5–10%)
This list of costs is a significant requirement – there is little flexibility for budget changes after the loan is closed, and, unlike the VA, few add-on loans available.
Insurance and Building Permits
Lenders need to be sure you’ve got a licensed builder on board and that the building process, from the design phase to a completed construction, follows local building codes and all applicable laws. They’ll ask for:
- Builder’s risk insurance
- General liability insurance
- Copies of approved building permits
VA loans do not require this type of insurance when you’re using the VA backing for purchase unless you are building a new home under special VA construction loan programs.
Loan-to-Value (LTV) Ratio
Most construction loans max out 80% of the cost of the future value of the home, so you’ll need to cover the other 20% through a cash down payment.
VA loans, on the contrary, can provide financing up to 100%, and that’s a huge difference with eligible veterans who are able to get them.
Additional Considerations
Higher Interest Rates
Loans used to build are usually higher interest rates than regular, and usually are a variable rate, meaning fluctuating according to the current market rates. These rates come with risk, as lenders risk the changes fluctuation in value during the construction period.
Draw Schedule and Inspections
Proceeds are released periodically as the work is completed, in a draw schedule designed with project-milestone matching in mind. It means that one may have to redraw to check if the building is in progress.
Conversion to Permanent Mortgage
After construction, the loan becomes due, either paid off or converted to a long-term mortgage. A construction-to-permanent loan is a convenient alternative that eliminates the second closing.
Final Thoughts
A construction loan can be a fantastic financial tool to help you construct a custom home, but it is not without its set of complexities compared with a traditional or VA loan. Although both are designed to support homebuyers, comparing a VA loan vs construction loan shows significant differences in eligibility, required deposits, and project range.
If you are already a veteran or currently serving, then you’re probably going to want to look at VA loan options that may have zero-down financing and more relaxed approval requirements. But, for those who are dead set on constructing a new house, having a full understanding of construction loan requirements will prove useful in ensuring that you are not caught off-guard by any surprises, and that you will have a successful completion of your project from start to finish.