What Are Construction Loans And How Do They Work?

If you can’t find a suitable home to buy, you might consider building one instead. However, financing this type of project is somewhat different from borrowing money to purchase an existing property. An alternative to a home loan is a construction loan (also known as a construction mortgage). Here’s what you need to know about construction loans.

What is a construction loan?

A construction loan is a loan that finances the construction of a home (also known as a stick-built house), from the purchase of the land to the completed structure. Common types are stand-alone construction loans, which are short-term loans (usually for a one-year term) that provide funding only for the construction phase, and construction-to-permanent loans, which convert to a mortgage once construction is complete. Borrowers who take out a standalone construction loan often take out another mortgage to pay off the principal when it comes due.

What costs qualify for a construction loan?

Construction loans can be used to cover costs such as:

• land/plot
• contractor labor
• building materials
• permission

As the name suggests, construction loans cover the costs of building a home. Typically, this means costs associated with construction, such as contractor fees, labor costs, and permits. However, the funds can also be used to purchase the land or premises themselves.

However, construction loans do not include design costs. If you want to hire a professional architect or interior designer, you will have to cover the cost yourself.

How do construction loans work?

The initial term of a construction loan is usually one year or less, during which the project must be completed. Because construction loans work on very short schedules and are dependent on the progress of the project, you (or your general contractor) must provide the lender with a construction schedule, detailed plans, and a realistic budget. Based on that, the lender releases funds at various stages of the project, usually directly to the contractor.

Comparison of construction loans and traditional mortgages

Beyond cost and repayment schedule, there are some key differences between construction loans and mortgage loans.

• Distribution of funds: Unlike a mortgage or home equity loan, which is funded in a lump sum, the lender pays the construction loan money in stages as construction progresses on your new home. These draws tend to occur when major milestones are completed, such as the foundation being laid or the bones of the house beginning.
• repayment: With a home loan, repayment of principal and interest begins immediately. For construction loans, lenders typically only expect interest payments during the construction phase. Additionally, the borrower is only obligated to repay interest on the actual funds withdrawn to date until construction is completed.
• Involvement of inspection/appraiser: While a home is being built, the lender will have an appraiser or inspector check the home at various stages of construction. Once the work is approved, the lender will make an additional payment, called a drawdown, to the contractor. It is expected that four to six inspections will be conducted to monitor progress.
• requirements: Similar to home loans, construction loan borrowers must be financially stable and able to make a down payment. But with no real estate to value, lenders also want to see construction plans and a detailed overview of the project when deciding how much to lend.
• interest rate: Interest rates on construction loans are typically higher than traditional mortgage rates. Reason: There is no existing mechanism to provide collateral to back the loan. This means the lender takes on more risk.

Types of construction loans

Different types of construction loans are available to borrowers and are designed to suit different financial needs.

Loans from construction to permanent

With construction-to-permanent loans, once your home is completed and you move in, the loan converts to a traditional mortgage. Typically, you can choose a term of 15 to 30 years and a fixed or variable interest rate.

During the construction loan stage, you are only responsible for paying interest on the money withdrawn. After conversion, interest and principal payments begin just like any other mortgage.

Most construction loans are conventional loans (completely privately originated and financed), but there are also government versions. Other options include FHA construction-to-permanent loans (which have less stringent approval criteria and are particularly useful for some borrowers) and VA construction loans if you’re a qualified veteran.

No matter the type, the big advantage of a build-to-permanent approach is that you only have to pay one set of closing costs, reducing your overall expenses.

“You only close once, so you don’t have to pay double closing fees,” said Janet Bossi, senior vice president at Ocean First Bank in New Jersey.

Construction-only loan

Construction-only loans provide the funds needed to construct a home, but the borrower is responsible for repaying the loan in full at maturity, which is usually within a year. You can settle your debt with cash or take out a mortgage to pay it off.

Advantages of this approach: You may get better terms on your new mortgage. Still, construction-only loans can ultimately cost more than construction-to-permanent loans. This is because you are completing two separate loan transactions and paying two sets of closing costs (which tend to amount to several thousand dollars). And of course, you have to invest time and energy into buying a mortgage.

Another consideration: If your financial situation deteriorates during construction, you may not be able to qualify for a mortgage later and move into your new home.

renovation loan

If you want to upgrade your existing home rather than build one, you can compare home improvement loan options. These come in different forms depending on how much you want to spend on your project.

“If a homeowner is looking to spend less than $20,000, they can take out a personal loan or use a credit card to finance renovations,” said Steve Kaminsky, head of U.S. home lending at TD Bank. We may be able to consider that.” “For renovations starting around $25,000, a home equity loan or line of credit may be appropriate if the homeowner has accumulated equity in their home.”

Another viable option in an environment of low mortgage rates is a cash-out refinance, where a homeowner takes out a new mortgage for a higher amount than their current loan and receives the additional amount in a lump sum. However, as interest rates rise, cash-out refi becomes less attractive.

For REFIS or home equity loans, lenders generally do not have to disclose how the homeowner will use the funds. Homeowners manage their budgets, plans, and payments. For some home improvement loans, the lender will evaluate the builder, review the budget and oversee the drawing schedule.

owner builder construction loan

Owner-builder loans are construction-to-permanent or construction-only loans in which the borrower also acts as a home builder.

Most lenders do not allow borrowers to act as their own builder due to the complexity of home construction and the experience required to comply with building codes. Lenders will typically only allow if the borrower is a commercially licensed builder.

terminate the loan

According to Kaminski, a termination loan simply refers to a homeowner’s mortgage after the property has been constructed. Construction loans are taken out during the construction phase and repaid once construction is complete. You will then repay a regular mortgage, also known as a termination loan.

“Not all financial institutions offer construction-to-permanent financing, which requires one loan closing,” Kaminsky says. “A second closing may be required to move to a permanent mortgage or termination loan.”

construction loan interest rates

Unlike traditional mortgages, which have fixed rates, construction loans typically have variable rates that fluctuate based on the prime rate. This means your monthly payments may increase or decrease as rates change.

Construction loan rates are also typically higher than traditional mortgage rates. Part of the reason is because they are unsecured (backed by assets). With a traditional mortgage, your home acts as collateral. If you miss payments, your lender may foreclose on your home. In the case of home construction loans, lenders don’t have that option, so they tend to view these loans as a greater risk.

On average, you can expect interest rates on construction loans to be about 1 percentage point higher than traditional mortgage rates.

construction loan requirements

Companies offering construction loans typically require that borrowers:

• Be financially stable. To qualify for a construction loan, you need a low debt-to-income ratio and proof of sufficient income to repay the loan. You also usually need a credit score of at least 680.
• make down payment. As with most home loans, you’ll need to make a down payment when you apply for the loan. The amount depends on the financial institution you choose and the amount you’re looking to borrow to pay for construction, but construction loans typically require at least a 20% down payment.
• Make a construction plan. Lenders will want you to work with a reputable construction company or architect to develop detailed plans and schedules.
• get housing appraisal. Whether you get a construction-only loan or a construction-to-permanent loan, lenders want to make sure the home is worth (or is worth) the amount they’re financing. The appraiser evaluates the drawings and the value of the lot to arrive at an accurate price. With construction-to-permanent loans, the home serves as collateral for the mortgage after construction is complete.

How to get a construction loan

While getting approved for a construction loan may seem similar to the process of getting a mortgage, getting approved to start construction on a new home is a little more complicated. There are typically four steps you should follow:

1. Find a licensed contractor: Your lender will want to know whether the builder you choose has the expertise to complete your home. If you have friends who have built their own homes, ask them for recommendations. You can also find a contractor in your area by browsing NAHB’s directory of local home builders associations. Just as you would compare existing homes before purchasing a home, it’s wise to compare different builders to find the combination of price and expertise that fits your needs.
2. Find a construction loan lender: Contact several experienced construction loan lenders to learn more about their specific programs and procedures. If you’re having trouble finding a lender to work with, check out smaller local banks and credit unions. Compare construction loan rates, terms, and down payment requirements to ensure you’re getting the best deal possible for your situation.
3. Please gather your documents: Lenders are likely to require a written contract from the builder that includes detailed pricing and plans for the project. Be sure to have the builder’s references and any necessary documents proving their business credentials. You’ll also likely need to provide many of the same financial documents you would for a traditional mortgage, such as pay stubs and tax statements, which prove your income, assets, and employment.
4. Get pre-approved: Getting pre-approved for a construction loan can help you figure out how much money you can borrow for your project. This can be an important step to avoid paying for blueprints from an architect or creating blueprints for a home you can’t afford.
5. Get homeowners insurance: Even if you don’t yet live in the home, your lender will likely require a prepaid homeowner’s insurance policy that includes builder’s risk coverage. This way, if something happens during construction (for example, your property catches fire or someone vandalizes your building), you are protected.

construction loan FAQ

Additional reporting by Ashley Tilford