How to Get the Best Construction Loan Rates This Year

A construction loan is a short-term, interim loan used to finance the cost of building or renovating a home, commercial building, or other structure. Unlike a traditional mortgage, a construction loan provides financing just for the construction period alone and is not the permanent financing for the completed property.

Construction loans have some unique features and requirements compared to other types of loans:

  • Funds are disbursed in stages based on the progress of construction. This provides better oversight and control over the use of funds compared to a lump-sum disbursement.

  • Interest rates are variable and often higher than rates for conventional mortgages. However, construction loans can make new construction more affordable by spreading out financing over the building process.

  • Construction loans typically have terms of 9-24 months. Borrowers must refinance into permanent financing once the project is finished.

  • Stricter qualification standards, requiring borrowers to have considerable assets, cash reserves, and a good credit history.

  • Collateral for the loan is the property itself plus the materials and work that will go into it. The property may also need to be subdivided before getting a loan.

The main purpose of construction loans is to enable borrowers to build or renovate when they would otherwise lack the large lump sum required to pay contractors upfront. It allows progress payments to be made incrementally as work is completed. This facilitates new construction that might not otherwise be feasible.

Current Rates

Construction loans typically have variable interest rates that are tied to a benchmark like the Prime Rate or LIBOR. This means the exact rate can fluctuate over the course of the loan as these benchmarks change.

According to data from the Federal Reserve, as of January 2023 the average rate on new construction loans was around 7.5-8.5%. This is significantly higher than the 3-4% range that was common just a year ago before the Fed started raising interest rates to combat inflation.

Some of the top lenders in new construction lending include Wells Fargo, Chase, and smaller niche lenders that specialize in construction financing. Quotes from these lenders show new construction loan rates in the following ranges as of January 2023:

  • Wells Fargo: 8.99% – 9.99%
  • Chase: 8.75% – 9.25%
  • Builders Capital: 7.75% – 8.75%
  • 8.25% – 9.0%

So while there is some variation, most lenders are currently offering new construction loan rates between 8-9% for well-qualified borrowers. Rates are elevated due to the rising interest rate environment, but can still allow builders and buyers to finance projects at reasonable costs compared to other options.

Factors That Influence Rates

Construction loan rates can vary significantly based on several key factors:

  • Credit score – Borrowers with higher credit scores are seen as lower risk and will generally qualify for lower interest rates. Those with scores below 680 may have difficulty getting approved or will pay higher rates. Maintaining a credit score over 700 is ideal.

  • Loan-to-value ratio – The LTV compares the amount borrowed to the completed value of the property. The lower the LTV, the lower the rate since there is less risk for the lender. Ideal LTVs are below 80%.

  • Economic conditions – When the economy is strong, rates tend to be lower. In weak economies with high unemployment, rates rise. The Fed also influences rates.

  • Type of property – Loans for residential construction generally have lower rates than commercial projects. Unique properties like condos may also have higher rates.

  • Relationship with lender – Established relationships with local lenders may result in more favorable rates compared to larger, national lenders who focus mainly on credit scores and formulas.

  • Down payment – Like LTV, larger down payments reduce risk resulting in better rates. A 20% down payment gives access to the best rates.

  • Loan amount – Requesting smaller loan amounts often allows borrowers to get better interest rates. Loans above conforming loan limits will have higher rates.

  • Length of project – Shorter construction projects are seen as lower risk. Expect higher rates for projects lasting more than a year.

Focusing on these key factors allows borrowers to get the lowest rates possible for their construction loan. A strong credit score, reasonable LTV, large down payment, and relationship with a local lender makes the most impact.

Compare to Traditional Mortgages

Construction loans differ from traditional mortgages in a few key ways that impact the interest rates.

  • Construction loans are short-term loans that provide financing just for the construction period, which typically ranges from 6 months to 2 years. Traditional mortgages are long-term loans, often for 15-30 years. The shorter duration of a construction loan means the interest rate is usually higher than rates for long-term mortgages.

  • Construction loan rates are variable and adjust periodically during the construction phase, often every 1-3 months. Rates on traditional fixed-rate mortgages remain stable for the full term of the loan. Since construction loan rates fluctuate, the overall interest costs are usually higher than a fixed mortgage rate.

  • Construction loans are considered riskier by lenders because there’s no completed home as collateral yet. This extra risk gets built into the interest rate, making construction loan rates higher than rates for mortgages on existing homes.

  • Interest rates on construction loans are usually tied to a benchmark like the Prime Rate or LIBOR. When these benchmarks change, the construction loan rate adjusts. Traditional fixed-rate mortgages often have interest rates locked in for the full term.

  • Construction loans require paying interest-only during the building phase, while traditional mortgages have principal and interest payments. The interest-only feature leads to higher rates on construction loans.

So in summary, the short duration, variable rates, lack of completed collateral, interest-only payments, and linkage to external benchmarks all contribute to construction loan rates being considerably higher than rates for standard long-term mortgages. But the flexibility and interest-only payments help offset the higher rates for builders and developers.

Variable vs Fixed Rates

Construction loans typically come in two types: variable rate and fixed rate. Each has its own pros and cons that borrowers should consider when deciding which option makes more sense for their project.

Variable Rate Construction Loans

With a variable rate construction loan, the interest rate fluctuates over the course of the loan. The rate is tied to an index like the Prime Rate or LIBOR. When the index rate goes up or down, the construction loan rate adjusts accordingly.

Pros of variable rate construction loans:

  • Typically have lower starting interest rates than fixed rates
  • If rates fall, your payments fall too
  • Interest paid on the construction loan may be tax deductible

Cons of variable rate construction loans:

  • Rates may rise over the course of the project, increasing your payments
  • Difficult to calculate exactly what the total interest paid will be
  • Unpredictable monthly payments make budgeting challenging

Fixed Rate Construction Loans

Fixed rate construction loans lock in a set interest rate for the entire loan term. This means your payments remain the same from the day you take out the loan until the day you pay it off.

Pros of fixed rate construction loans:

  • Interest rate remains stable for the duration of the project
  • Easy to calculate total interest costs for project budget
  • Predictable monthly payments help with budgeting

When deciding between variable and fixed, it’s a tradeoff between lower starting rates and predictable payments. Consider the pros and cons in the context of your project timeline and budget needs.

 Interest-Only Payments

During the construction phase of a construction loan, borrowers typically only pay the interest on the loan each month, not the principal. This helps keep payments lower during the building process when cash flow may be tighter.

With interest-only payments:

  • The loan balance remains the same each month.
  • Your monthly payment only covers the interest accrued for that period.
  • You’re not paying against the principal loan amount.
  • This makes payments more affordable in the short term.

For example, say you take out a $200,000 construction loan at 5% interest. Your monthly interest-only payment would be around $833. This is calculated by multiplying the loan amount by the interest rate, then dividing by 12 months ($200,000 x 0.05 / 12 = $833).

The full loan balance would still be due once construction is finished. At that point, the construction loan usually converts to a traditional mortgage with principal and interest payments.

Interest-only construction loans provide more flexible, affordable payments during the building process. This helps manage cash flow when you have construction costs to cover. However, you need a plan to pay off the principal once the construction period ends.

 Draw Schedule

The draw schedule outlines when and how the borrower can access the funds from the construction loan. With a construction loan, the full amount is not given upfront. Instead, the funds are released in stages as the project progresses. This process of periodically “drawing down” money from the loan is determined by the draw schedule.

The draw schedule is typically tied to completion of certain stages of the construction project. For example, the schedule may allow the first 10% of funds to be drawn when the foundation is poured. Another 20% may be available when framing is complete. Subsequent draws are then allowed as other milestones are reached, like roofing, plumbing, electrical, drywall, etc.

The builder will submit a draw request to the lender outlining the completed work and percentage of funds being requested. The lender will then send an inspector to verify progress before releasing the funds. Draw requests are usually allowed on a monthly basis, although some lenders may provide more frequent draws.

The draw schedule ensures the work is being completed as planned before more funds are released. This protects the lender by allowing them to confirm real progress is happening. For borrowers, following the draw schedule is mandatory – draws cannot be requested ahead of schedule just because funds are needed. Working closely with the lender to understand the requirements upfront is important.

 Rollover to Permanent Financing

Once construction is completed, the construction loan will need to be paid off or rolled over into permanent financing. This is an important consideration when taking out a construction loan initially.

There are a few options for obtaining permanent financing after the home is built:

– Convert the construction loan to a traditional mortgage – Many lenders will allow you to convert or ‘roll over’ the construction loan into a fixed-rate or adjustable-rate mortgage once construction is finished. This avoids having to apply and close on a new loan.

– Obtain a new traditional mortgage – You can choose to apply for and close on a new permanent mortgage loan once construction is complete. This allows you to shop different lenders and lock in current interest rates. Just be sure to begin the process early so you can close on time.

– Pay off the construction loan in cash – If you have the funds, you can pay off the construction loan entirely in cash when construction is finished. You would then own the home free and clear without a mortgage.

– Secure a bridge loan – A bridge loan provides short-term financing to transition from the construction loan to permanent financing. It gives you more time to sell an existing home or wait for the best mortgage rates.

No matter the option chosen, it’s important to have a plan for permanent financing before beginning construction. Talk to your lender about the optimal loan structure and timeline for transitioning to a traditional mortgage or other permanent financing. Careful planning will ensure you don’t end up paying off the construction loan from higher cost sources.

 Tips for Getting the Best Rate

When it comes to securing the best possible construction loan rate, there are several key factors to focus on:

Credit Score

Your credit score will play a major role in determining the interest rate you can qualify for. Lenders view borrowers with higher credit scores as less risky, so they reward them with lower rates. Before applying, aim to improve your score as much as possible by paying down debts, ensuring no late payments, and limiting new credit inquiries. A score of 740 or higher will put you in excellent shape.

Down Payment

The more you can put down as a down payment, the better your rate will generally be. A down payment of at least 20% is ideal, as it shows you have more skin in the game and makes the loan less risky for lenders. Even a 10-15% down payment can result in a decent rate improvement over putting little to nothing down. Save aggressively for your down payment to maximize your leverage in rate negotiations.

Contractor Relations

Having a strong relationship with an experienced general contractor that the lender is familiar with can improve your chances of getting approved and securing a competitive rate. Respected contractors with a track record of successful projects are seen as lower risk partners. Discuss contractor options with your lender early in the process.

Loan Shopping

Applying to multiple lenders rather than just accepting the first rate you’re quoted is essential. Even a 0.5% difference in rate can save you thousands over the life of the construction loan. Be sure to get rate quotes from local banks, credit unions, and online lenders to find the best deal. Locking in your rate as early as possible is advised to avoid fluctuations.

By focusing on these key tips, you can put yourself in a strong position to secure the most favorable interest rate possible on a construction loan. A lower rate saves money and makes projects more affordable.

 Alternatives to Consider

Construction loans are specialized financial products that may not be right for every homebuilding project. Here are some alternatives to explore:

 Bridge Loans

Bridge loans are short-term loans meant to bridge the gap between buying a new property and selling an existing one. They can provide funds for construction or renovations for up to 12 months. Bridge loans typically have higher interest rates and require a lump sum payment at the end.

 Renovation Loans

Some lenders offer renovation loans tailored for home improvement projects up to $35,000. These loans don’t require monthly payments during the renovation phase. The borrowed amount is rolled into the overall mortgage at the project’s completion.

 FHA 203(k) Loan

This government-backed mortgage covers purchasing a home and financing its renovation through a single loan. Borrowers can get up to $35,000 for minor renovations or up to 50% of the home’s value for major overhauls. These loans have lower down payments and interest rates.

 Home Equity Loan/Line

Existing homeowners can leverage their home equity to finance construction projects. These loans use your home as collateral and typically have lower interest rates than other options. You only pay interest on the amount borrowed.

Many alternatives exist beyond construction loans. Weigh the pros and cons of each option for your specific project and budget. Consulting a financial advisor can provide personalized guidance on the optimal financing path forward.

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