What are construction loans, and how do they work?

If you can’t find the right home to buy, you might be thinking about how much it will cost to build a new house or renovate the one you currently call home. The process of borrowing the money to pay for this project is different from getting a mortgage to move into an existing property. Here’s everything you need to know about getting a construction loan.

What is a construction loan?

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

Construction loans typically are one year in duration. During this time, the property must be built and a certificate of occupancy should be issued.

How do construction loans work?

1. The borrower applies for a construction loan, submitting financials, plans and project timelines.
2. If approved, the borrower starts drawing funds in conjunction with each phase of the project, typically only repaying interest during construction. Throughout construction, an appraiser or inspector assesses the build to authorize more funds.
3. Once construction finishes, the borrower usually converts to the loan to a permanent mortgage and begins repaying both principal and interest.

Construction loans usually have variable rates that move up and down with the prime rate. Construction loan rates are typically higher than traditional mortgage loan rates. 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 traditional mortgage rates, usually falling somewhere between 5 and 10 percent.

The initial loan term generally lasts the length of your construction project. Because construction loans are on such a short timetable and they’re dependent on the completion of the project, you need to 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 the construction loan 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 be required to get a separate mortgage designed to pay off the construction loan.

Differences between construction loans and traditional mortgages

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

• The loan money distribution. Unlike mortgages and personal loans that make 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 money the borrower owes. With a mortgage, you start paying principal and interest right away. With construction loans, you will typically be expected to make only interest payments 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 stages of construction. If approved by the appraiser, the lender makes additional payments to the contractor, known as draws. Expect to have between four and six inspections to monitor the progress.

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, and 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 complete the building of the home, but the borrower is responsible for either paying the loan in full at maturity (typically one year or less) or obtaining a mortgage to secure permanent financing.

The funds from these construction loans are disbursed based upon the percentage of the project completed, and the borrower is only responsible for interest payments on the money drawn.

Construction-only loans can ultimately be costlier if you will need a permanent mortgage 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,” Steve Kaminski, head of U.S. Residential Lending at TD Bank, says. “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 at a higher amount than their current loan and receive that overage in a lump sum. As rates tick up, though, this option becomes 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 where 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 experience required to comply with building codes. Lenders that do 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, Kaminski explains. A construction loan is used during the building phase and is repaid once the construction is completed. A borrower will then have their 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. Some require a second closing to move into the permanent mortgage, or an end loan,” Kaminski says.

What does a construction loan cover?

Some things a construction loan can be used to cover include:

• The cost of the land
• Contractor labor
• Building materials
• Permits

It’s important to discuss these items with your lender, specifically what will be included in your loan-to-value calculation, according to Kaminski.

“Oftentimes, construction loans will include a contingency reserve to cover unexpected costs that could arise during construction, which also serves as a cushion in case the borrower decides to make any upgrades once the construction begins,” Kaminski says. “It’s not uncommon for a borrower to want to elevate their countertops or cabinets once the plans are laid

Other costs to build a house

Building a home costs more than just the material and labor required to erect the structure itself. Fortunately, the cost of permanent fixtures like appliances and landscaping can generally be included in the loan amount. Home furnishings, on the other hand, are not covered within a construction loan out.”

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 a way to prove 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. 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 it was put together by the construction company you’re going to work with, it can help lenders feel more confident 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.

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, if you’re wondering how to get a construction loan, you should follow these four steps:

1. Find a licensed builder: Any lender is going to want to know that the builder in charge of the project 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.
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.

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.

Factors to consider about construction loans

Before you apply for a construction loan, ask yourself these key questions.

Could your project face significant timeline issues?

Talk to your contractor and discuss the timeline of building the home and if other factors could slow down the job. Keep in mind there are still bottlenecks plaguing production, which first started with pandemic supply-chain disruptions and still persist. Be prepared for material prices to stay high, especially in light of inflation, and ongoing shortages to affect your project.

Do you want to simplify the borrowing experience?

Decide if you want to go through the loan process once with a construction-to-permanent loan or twice with a construction-only loan. Consider how much the closing costs and other fees of obtaining more than one loan will add to the project.

When getting a construction loan, you might not just be accounting for building the house; you may also need to purchase the land and figure out how to handle the total cost later, perhaps with a permanent mortgage when the home is finished. In that case, a construction-to-permanent loan can make sense in order to avoid multiple closings. If you already have a home, though, you might be able to use the proceeds to pay down the loan. In that case, a construction-only loan might be a better choice.

What is the drawing process from your 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 your contractor can use it.

Understanding this process — and ensuring your contractor does, too — can help to avoid delays because of insufficient funds.

How to find a construction loan lender

Check with several experienced construction loan lenders to obtain details about their specific programs and procedures, and 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,” Bossi says.

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.