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A construction loan sounds pretty straightforward. Historically, borrowers got them when building a new home on a plot of land. In recent years, more borrowers have been using construction loans for projects like an accessory dwelling unit (ADU), a tiny house on a foundation, garage-to-apartment conversion, or basement conversion. But there are complications with this kind of loan that people should be aware of.

We’ll take a look at construction loans, their requirements, and some alternatives to consider.

What Is a Construction Loan?

Construction loans finance the building of a new home or substantial renovations to a current home. They are typically short-term loans with higher interest rates, designed to cover the costs of land, plans, permits and fees, labor, materials, and closing costs. They also cover contingency reserves if construction goes over budget.

How Do Construction Loans Work?

When you buy a house, you can finance the purchase with a mortgage. But when you build a house, getting financing is trickier because there’s no collateral to guarantee the loan. Lenders generally don’t accept undeveloped land as collateral because it cannot be easily appraised and quickly sold.

With construction loans, applicants must submit project plans and schedules along with their financial information. Once approved, they receive funding for the first phase of building only. As construction progresses, assessments are provided to the lender so that the next round of funds can be released. Meanwhile, borrowers make interest-only payments on the funds they’ve received.

When construction is finished — and the borrower now has a home to serve as collateral — the construction loan may be converted to or paid off by a regular mortgage. The borrower then begins repaying both the principal and interest.

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What Does a Construction Loan Cover?

What construction loans cover varies based on the borrower’s needs. If necessary, these loans can cover the cost of the land, building labor and materials, permits, and a contingency cushion for unforeseen expenses.

Types of Construction Loans

Construction-to-Permanent Loan

Sometimes referred to as a single-close loan, this is a construction loan that converts to a mortgage once the project is finished. The borrower saves money on closing costs by eliminating a second loan closing.

Construction-Only Loan

Also called a standalone construction loan, this loan must be paid off when the building is complete. You will need to apply for a mortgage if you don’t have the cash to do so.

Having separate construction and mortgage loans allows homeowners to shop for the best terms available when applying for each loan. However, they will pay separate closing costs on each loan.

Renovation Construction Loan

This is specifically designed to cover the cost of substantial renovations on an existing home. The loan gets folded into the mortgage once the project is complete.

What Are the Requirements for a Construction Loan?

It’s typically harder to get a construction loan than it is to secure a mortgage. Some people even hire construction loan brokers to facilitate the process. Because your house or ADU isn’t built yet, as we mentioned above, there’s no collateral. And because there’s no collateral, lenders will want to see strong evidence that the home will be completed.

A loan that doesn’t require collateral is also known as an “unsecured loan.” You can learn more about the two types of loans in our guide to secured vs. unsecured loans.

With renovations, the lender wants to see that the project will add to the value of the home. To get an idea of the ROI on your renovation project, check out SoFi’s Home Project Value Estimator.

In order to get approved, you’ll have to show your potential lender an overview of your financial profile, with plenty of documentation. They’ll typically want to see a debt-to-income ratio of 45% or lower and a high credit score.

For new construction projects, they’ll also want you to be able to make a down payment of up to 30%. And for construction-only loans, they may want to know what your repayment plan is — that is, whether you will pay in cash or refinance when the project is complete.

In addition, the lender will want a detailed plan, budget, and schedule for the construction. Some lenders will also need to approve your builder. Because the project will depend on the builder’s ability to complete the construction to specifications, your builder’s reputation may be crucial to getting a construction loan approved.

Lenders typically need to see a builder’s work history, proof of insurance, blueprints, and specifications for the project, a materials list, and your signed construction contract.

What Are the Average Interest Rates and Terms?

Typically, construction loans have variable interest rates that rise and fall with the prime lending rate. They tend to be higher than conventional mortgage rates by about 1%.

The terms also vary. A construction-only loan is usually a short-term loan that must be converted or paid off in one year.

A construction-to-permanent loan will typically have a term of 15 to 30 years once it becomes a permanent mortgage. Again, though, the interest rate will usually be higher than a conventional loan because of the increased risk. The longer the term, the higher the rate tends to be.

Are There Alternatives to Construction Loans?

A lot of time and effort may go into securing a construction loan. It can be difficult to find lenders that offer competitive rates and to qualify for them — particularly if you don’t have a flawless credit history. Plus, construction loans tend to be complicated because it is often the builder who has to carry the loan.

If you are planning a small construction project or renovation, there are a few financing alternatives that might be easier to access and give you more flexibility.

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Personal Loans for Renovations

An unsecured personal loan can fund a renovation project or supplement other construction financing.

Personal loan interest rates are typically lower than construction loan rates, depending on your financial profile. And you can frequently choose a personal loan with a fixed interest rate.

Personal loans also offer potentially better terms. Instead of being required to pay off the loan as soon as the home is finished, you can opt for a longer repayment period. And getting approved for a personal loan can be much faster and easier than for a construction loan.

The drawbacks? You won’t be able to roll your personal loan into a mortgage once your renovation or building project is finished.

And because the loan is disbursed all at once, you will have to parse out the money yourself, instead of depending on the lender to finance the build in stages.

Cash-Out Refinance for Construction Costs

A cash-out refinance is also a good financing tool, particularly if you have a lot of equity in your current home. With a cash-out refinance, you refinance your home for more than you owe and are given the difference in cash.

You can estimate your building or renovation expenses with this Home Improvement Cost Calculator. Add your estimate to what you owe on your home to get the amount of your refinance.

Using one — or both — of these alternative financing tools may help you avoid some of the hassle and expense that come with construction loans.

The Takeaway

Planning a new home, ADU, or substantial renovation? A construction loan may be the ticket, though this kind of loan is usually harder to get than a mortgage, often carries a higher interest rate, and is typically short-term. For smaller projects, a personal loan or cash-out refinance can be a good option — and a lot less complicated.

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Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.

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An equal-weight index gives each constituent the same weight in the index, versus a market-cap-weighted or price-weighted index, where bigger companies (or those trading at higher prices) hold a larger share of the index.

Equal weighting strives to equalize the impact of each company’s performance on the overall index. Traditional market-cap weighting tends to give bigger companies more influence over outcomes.

Equal-weight investing is a smart beta strategy that may appeal to certain types of investors more than others. This article will delve deep into equal-weight investing, including:

•   What Is an Equal Weighted Index?

•   How to Calculate an Equal Weighted Index.

•   Advantages of Using an Equally Weighted Index.

•   Disadvantages of Using an Equally Weighted Index.

What Is an Equal-Weighted Index?

A stock market index tracks the performance of a specific group of stocks or a particular sector of the market. For example, the S&P 500 Composite Stock Price Index tracks the movements of 500 companies that are recognized as leaders within their respective industries.

Stock market indices are often price-weighted or capitalization-weighted.

•   In a price-weighted index, the stocks that have the highest share price carry the most weight. In a capitalization-weighted index, the stocks with the highest market capitalization carry the most weight.

•   Market capitalization represents the value of a company as measured by multiplying the current share price by the total number of outstanding shares.

While some investors may wish to invest in stocks, others may be interested in mutual funds or index funds, which are like a container holding many stocks.

How Equal Weighting Works

An equal-weighted index is a stock market index that gives equal value to all the stocks that are included in it. In other words, each stock in the index has the same importance when determining the index’s value, regardless of whether the company is large or small, or how much shares are trading for.

An equally weighted index essentially puts all of the stocks included in the index on a level playing field when determining the value of the index. With a price-weighted or capitalization-weighted index, on the other hand, higher-priced stocks and larger companies tend to dominate the index’s makeup — and thereby dictate or influence the overall performance of that index.

This in turn influences the performance of corresponding index funds, which track that particular index. Because index funds mirror a benchmark index, they are considered a form of passive investing.

Most exchange traded funds (ETFs) are passive funds that also track an index. Now there are a growing number of actively managed ETFs. While equal-weight ETFs are considered a smart beta strategy, they aren’t fully passive or active in the traditional sense. These funds do track an index, but some active management is required to rebalance the fund and keep the constituents equally weighted.

Examples of Equal-Weight Funds

Equal-weight exchange-traded funds (ETFs) have grown more common as an increasing number of investors show interest in equal-weight funds. Equal weight falls under the umbrella of smart-beta strategies, which refers to any non-market-capitalization strategy.

The term “smart beta” doesn’t mean a particular strategy is better or more effective than others.

Equal-weight funds, for example, are designed to shift the weight of an index and its corresponding funds away from big cap players, which can unduly influence the performance of the index/fund. And while an equal-weight strategy may have improved fund performance in some instances, the results are inconsistent.

Here is a list of the top five equal-weight ETFs by assets under management (AUM), according to ETF.com.

1.    Invesco S&P 500 Equal Weight ETF (RSP )

2.    SPDR S&P Biotech (XBI )

3.    SPDR S&P Oil and Gas Exploration and Production (XOP )

4.    SPDR S&P Global Natural Resources ETF (GNR )

5.    First Trust Cloud Computing ETF (SKYY )

How to Calculate Equal-Weighted Index

To calculate equal weighted index, you need to know two things:

•   The share price of each stock that’s included in the index

•   Total number of stocks included in the index

If you’re calculating an equally weighted index value for an index that has five stocks in it, each one would be weighted 20%, regardless of its stock price or market capitalization. To find an equal-weighted index value, you would simply add the share price of each stock together, then multiply it by the weight.

So for example, say an index has five stocks priced at $100, $50, $75, $90 and $85. Each one would be weighted at 20%.

Following the formula, you would add each stock’s price together for a total of $400. You’d then multiply that by the 20% weighting to arrive at an equal-weighted value of 80.

As fund turnover occurs and new assets are exchanged for old ones, or as share prices fluctuate, the equally weighted index value must be recalculated.

The equally weighted index formula can be used to determine the value of a particular index. You may want to do this when determining which index ETF to invest in or whether it makes sense to keep a particular index mutual fund in your portfolio.

Advantages of Using an Equally Weighted Index

An index investing strategy might be preferable if you lean toward more conservative investments or you simply want exposure to a broad market index without concentrating on a handful of stocks. That’s something you’re less likely to get with mutual funds or ETFs that follow a price-weighted or capitalization-weighted index.

Here are some of the reasons to consider an equal-weighted index approach:

•   An equal-weight strategy can increase diversification in your portfolio while potentially minimizing exposure to risk.

•   It’s relatively easy to construct an equally weighted portfolio using index mutual funds and ETFs.

•   It may appeal to value investors, since there’s less room for overpriced stocks to be overweighted and undervalued stocks to be underweighted.

•   Equal-weighted indices may potentially generate better or more incremental returns over time compared to price-weighted or capitalization-weighted indices, but there are no guarantees.

Disadvantages of Using Equally Weighted Index

While there are some pros to using an equal weighted approach, it may not always be the best choice depending on your investment goals. In terms of potential drawbacks, there are two big considerations to keep in mind:

•   Equal-weighted index funds or ETFs that have a higher turnover rate may carry higher expenses for investors.

   There is typically a constant buying and selling of assets that goes on behind the scenes to keep an equal-weighted mutual fund or ETF in balance.

   Higher turnover ratios, i.e. how often assets in the fund are swapped in and out, can lead to higher expense ratios if a fund requires more active management. The expense ratio is the price you pay to own a mutual fund or ETF annually, expressed as a percentage of the fund’s assets. The higher the expense ratio, the more of your returns you hand back each year to cover the cost of owning a particular fund.

•   Equal-weighted indices can also be problematic in bear market environments, which are characterized by an overall 20% decline in stock prices. During a recession, cap-weighted funds may outperform equal-weighted funds if the fund is being carried by a few stable, larger companies.

◦   Conversely, an equal-weighted index or fund may miss out on some of the gains when markets are strong and bigger companies outperform.

The Takeaway

In an equal-weight index, each stock counts equally toward the index’s value, regardless of whether the company is large or small, or what shares are currently trading for. The same is true of any corresponding fund.

There are advantages to investing in an equal-weight index fund over a capitalization-weighted index or price-weighted index. For example, equal-weighted indices may generate better or more consistent returns. Investing in an equal-weight index may be appealing to investors who prefer a value investing strategy or who want to diversify their portfolio to minimize risk.

With a SoFi Invest online trading account, you can begin building your portfolio using SoFi’s streamlined, secure investing app. You can follow a DIY path by choosing which stocks or ETFs to invest in, in addition to many other options including fractional shares, IPO shares, and more. SoFi doesn’t charge any commission, and members have access to complimentary financial advice from professionals.

FAQ

How do equal-weight ETFs work?

Like an equal-weight index, an equal-weight ETF holds the same proportion of each of its constituents, which in theory may equalize the impact of different companies’ performance.

When should you buy equal-weighted ETFs?

If you’d like to invest in a certain sector, but you don’t want to be riding the coattails of the biggest companies in that sector because you see the value in other players, you may want to consider an equal-weight ETF.

What is the equally weighted index return?

The return of an equally weighted index would be captured by the performance of an investment in a corresponding index fund or ETF. So if you invest $100 in Equal Weight Fund A, which tracks an equal weight index, and the fund goes up or down by 5%, you would see a 5% gain or loss.

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