What are construction loans, and how do they work?

If you can’t find the right home to buy, you might be thinking about building a house instead. Financing this sort of project is somewhat different from getting a mortgage to move into an existing property, though. Instead of a mortgage, you have to take on a different sort of debt: a construction loan (also known as a construction mortgage).

Here’s everything you need to know about getting a construction loan, from how they work to what they cost.

How do construction loans work?

A home construction loan is a short-term, high-interest product that provides the funds required to build a residential property.

You can use a construction loan to cover costs including:

• The land
• Contractor labor
• Building materials
• Permits

The initial term on a construction loan generally lasts a year or less, during which time you must finish your construction project. Because construction loans work on such a short timetable and they’re dependent on the project’s progress, you (or your general contractor) must provide the lender with a construction timeline, detailed plans and a realistic budget.

Depending on the type of construction loan, you might be able to convert it to a traditional mortgage once the home is built. This is known as a construction-to-permanent loan. If the loan is solely for the construction phase, you might need to get a separate mortgage to pay off the construction loan.

Construction loans vs. traditional mortgages

Beyond the cost and repayment timeline, construction loans and mortgages have a few main differences:

• The funds distribution: Unlike mortgages and personal loans that provide funds in a lump-sum payment, the lender pays out the money for a construction loan in stages as work on the new home progresses. These draws tend to happen when major milestones are completed — for example, when the foundation is laid or the framing of the house begins.
• The repayments: With a mortgage, you start paying back the principal and interest right away. With construction loans, your lender will typically expect you to make interest payments only during the construction stage. Additionally, borrowers are typically only obligated to repay interest on any funds drawn to date until construction is completed.
• Inspection/appraiser involvement: While the home is being built, the lender has an appraiser or inspector check the house during the various construction stages. If everything is approved, the lender makes additional payments to the contractor, known as draws. Expect to have between four and six inspections to monitor the progress.

Construction loan requirements

The companies that offer construction loans usually require borrowers to:

• Be financially stable. To get a construction loan, you’ll need a low debt-to-income ratio and proof of sufficient income to repay the loan. You also generally need a credit score of at least 680.
• Make a down payment. You need to make a down payment when you apply for the loan, just as you do with a mortgage: The lender won’t finance 100 percent of the project. The amount will depend on the lender you choose and the amount you’re trying to borrow to pay for construction, but construction loans usually require at least 20 percent down.
• Have a construction plan. If you have detailed plans and a project schedule, especially if the construction company you’re going to work with put it together, it can help reassure lenders that everything will go according to that plan and you’ll be able to repay the loan.
• Get a home appraisal. The finished home will serve as collateral for the loan, so lenders want to make sure the collateral will be sufficient to secure the loan. For that, they may require you to get an appraisal estimating how much the finished home will be worth.

Types of construction loans

Construction-to-permanent loan

With a construction-to-permanent loan, you borrow money to pay for the cost of building your home. Once the house is complete and you move in, the loan is converted to a permanent mortgage.

The benefit of the construction-to-permanent approach is that you have only one set of closing costs to pay, reducing your overall fees.

“There’s a one-time closing so you don’t pay duplicate settlement fees,” says Janet Bossi, senior vice president at OceanFirst Bank in New Jersey.

Once the construction-to-permanent shift happens, the loan becomes a traditional mortgage, typically with a loan term of 15 to 30 years. Then, you make payments that cover both interest and the principal. At that time, you can opt for a fixed-rate or adjustable-rate mortgage. Your other options include an FHA construction-to-permanent loan — with less-stringent approval standards that can be especially helpful for some borrowers — or a VA construction loan if you’re an eligible veteran.

Construction-only loan

A construction-only loan provides the funds necessary to build the home, but the borrower is responsible for either paying the loan in full at maturity (typically one year or less) or getting a mortgage to secure permanent financing.

Your lender disburses the funds from these construction loans based upon the percentage of the project completed, and you’re only responsible for interest payments on the money drawn.

Construction-only loans can ultimately be costlier if you then end up needing a permanent mortgage. That’s because you complete two separate loan transactions and pay two sets of fees. Closing costs tend to equal thousands of dollars, so it helps to avoid another set.

Another consideration is that your financial situation might worsen during the construction process. If you lose your job or face some other hardship, you might not be able to qualify for a mortgage later on — and might not be able to move into your new house.

Renovation loan

If you want to upgrade an existing home rather than build one, you can compare home renovation loan options. These come in a variety of forms depending on the amount of money you’re spending on the project.

“If a homeowner is looking to spend less than $20,000, they could consider getting a personal loan or using a credit card to finance the renovation,” says Steve Kaminski, head of U.S. Residential Lending at TD Bank. “For renovations starting at $25,000 or so, a home equity loan or line of credit may be appropriate, if the homeowner has built up equity in their home.”

Another viable option in a low mortgage rate environment is a cash-out refinance, whereby a homeowner would take out a new mortgage in a higher amount than their current loan and receive the extra as a lump sum. As rates tick up, though, cash-out refis become less appealing.

With any of these options, the lender generally does not require disclosure of how the homeowner will use the funds. The homeowner manages the budget, the plan and the payments. With other forms of financing, the lender will evaluate the builder, review the budget and oversee the draw schedule.

Owner-builder construction loan

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

Most lenders won’t allow the borrower to act as their own builder because of the complexity of constructing a home and the experience required to comply with building codes. Lenders typically only allow it if the borrower is a licensed builder by trade.

End loan

An end loan simply refers to the homeowner’s mortgage once the property is built, says Kaminski. You use a construction loan during the building phase and repay it once the construction is completed. You’ll then have a regular mortgage to pay off, also known as the end loan.

“Not all lenders offer a construction-to-permanent loan, which involves a single loan closing,” says Kaminski. “Some require a second closing to move into the permanent mortgage, or an end loan.”

How to get a construction loan

Getting approval for a construction loan might seem similar to the process of obtaining a mortgage, but getting approved to break ground on a brand-new home is a bit more complicated. Generally, you should follow these four steps:

1. Find a licensed builder: Lenders will want to know that your chosen builder has the expertise to complete the home. If you have friends who have built their own homes, ask for recommendations. You can also turn to the NAHB’s directory of local home builders’ associations to find contractors in your area. Just as you would compare multiple existing homes before buying one, it’s wise to compare different builders to find the combination of price and expertise that fits your needs.
2. Get your documents together: A lender will likely ask for a contract with your builder that includes detailed pricing and plans for the project. Be sure to have references for your builder and any necessary proof of their business credentials. You will also likely need to provide many of the same financial documents as you would for a traditional mortgage, like pay stubs and tax statements, that offer proof of income, assets and employment.
3. Get preapproved: Getting preapproved for a construction loan can provide a helpful understanding of how much you will be able to borrow for the project. This can be an important step to avoid paying for plans from an architect or drawing up blueprints for a home that you will not be able to afford.
4. Get homeowners insurance: Even though you may not live in the home yet, your lender will likely require a prepaid homeowners insurance policy that includes builder’s risk coverage. This way, if something happens during the construction process — the halfway-built property catches on fire, or someone vandalizes it, for example — you are protected.

Construction loan FAQs

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  What are construction loan rates?

  Unlike traditional mortgages, which carry fixed rates, construction loans usually have variable rates that move up and down with the prime rate. That means your monthly payment can also change, moving upward or downward based on rate changes.
  
  Construction loan rates are also typically higher than traditional mortgage loan rates. That’s partially because they’re unsecured (backed by an asset). With a traditional mortgage, your home acts as collateral — if you default on your payments, the lender can seize your home. With a home construction loan, the lender doesn’t have that option, so they tend to view these loans as bigger risks.
  
  On average, you can expect interest rates for construction loans to be about 1 percentage point higher than those of traditional mortgage rates.
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  How can you find a construction loan lender?

  Check with several experienced construction loan lenders to obtain details about their specific programs and procedures. Compare construction loan rates, terms and down payment requirements to ensure you’re getting the best possible deal for your situation.
  
  “Because construction loans are more complex transactions than a standard mortgage, it is best to find a lender who specializes in construction lending and isn’t new to the process,” says Bossi.
  
  If you have trouble finding a lender willing to work with you, check out smaller regional banks or credit unions. They might be more flexible in their underwriting if you can show that you’re a good risk, or, at the very least, have a connection they can refer you to.
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  How do I draw money from my construction loan?

  Ask your lender how money gets disbursed from your loan amount. Some lenders allow for monthly draws, while others will only authorize a draw after a passed inspection. Inquire about any processes or documentation required to pull money from your construction loan so that you can pay the bills in a timely fashion as they come in.
  
  Understanding this process — and ensuring your contractor does, too — can help to avoid delays because of insufficient funds.
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  What if my construction project takes longer than expected?

  Talk to your contractor and discuss the timeline of building the home and what sort of factors could slow down the job. Delays could result in changes to your loan’s interest rate, which can lead to higher payments. Delays can also lead to delays in fund disbursement for construction-only loans.
  
  If your project takes longer than expected, work with your contractor to try to resolve any bottlenecks. You should also keep in touch with your lender to let them know what’s going on. Clear and consistent communication can help avoid major issues with the loan.
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  Is it harder to qualify for construction loans?

  It can be. To qualify for a construction loan, most lenders require a credit score of at least 680 — which is higher than what you’d need for most conventional, VA, and FHA loans. It’s also typical for lenders to ask for a minimum down payment of 20 percent on construction loans, so you may have trouble qualifying if you can’t get that much money together up front.
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  Do construction loans cover home design?

  No. If you want to hire a professional to design your new home, you’ll need to cover those costs yourself.