Two people on site of a house being built
Chris Ryan/Getty Images

It’s exciting to have a home built for you, but the intricacy and unfamiliarity of mortgage loans for new construction can temper your enthusiasm.

Learn the basics of home construction loans and be ready when you decide to build your own home.

2 types of home construction loans

There are two main types of home construction loans:

  • Construction-to-permanent: You borrow to pay for construction. When you move in, the lender converts the loan balance into a permanent mortgage. It’s two loans in one.
  • Stand-alone construction: Your first loan pays for construction. When you move in, you get a mortgage to pay off the construction debt. It’s two separate loans.

Construction-to-permanent loans

You have only one closing with a construction-to-permanent loan, which reduces the fees you pay.

During the construction phase, you pay interest only on the outstanding balance. The interest rate is variable during construction, moving up or down with the prime rate. If the Federal Reserve raises or decreases short-term interest rates while the house is being built, your interest rate will change.

The lender converts the construction loan into a permanent mortgage after the contractor finishes building the home. The permanent mortgage is like any other mortgage. You can choose a fixed-rate or an adjustable-rate loan and specify the loan’s term, typically 15 years or 30 years. When you’re ready, shop and compare mortgage rates.

Many lenders let you lock a maximum mortgage rate when construction begins. Lenders generally require a down payment of at least 20 percent of the expected amount of the permanent mortgage. Some lenders make exceptions.

Stand-alone construction loans

A stand-alone construction loan can work out well if it allows you to make a smaller down payment. That can be a major advantage if you already own a home and don’t have much cash for a down payment but you will have more cash after you sell your home. You can live in your current home while your next home is under construction.

This type of loan has drawbacks, though:

  • You pay for two closings and two sets of fees — first, on the construction loan; second, on the permanent mortgage.
  • You can’t lock a maximum mortgage rate. If rates rise during construction, you might have to pay a higher-than-expected interest rate on the permanent loan.

And if your financial circumstances change for the worse during construction, you may find it difficult or impossible to qualify for a mortgage.

Qualifying for a construction loan is harder

When you apply for a loan to build a home, the lender doesn’t have a complete home as collateral, so qualifying for a loan can be more difficult. The lender will want details about the home’s size, the materials used and the contractors and subcontractors who do the work. The general contractor can pull all this information together.

On top of that, the lender needs to know that you can make your monthly loan payments during construction. If the lender thinks you can’t make your current rent or mortgage payments while your house is being built, you won’t qualify.

If you’re confident you can qualify, use Bankrate’s mortgage-comparison tool.

Adequate savings for unexpected costs a must

The lender will make sure you have savings to pay for unexpected costs. “There are always cost overruns when you are building a home that you may not know about until you are into it. We don’t want them to use every last dime they have before they start,” said Dennice Henshaw, former eastside division manager for Washington Federal in Seattle.

Cost overruns are incurred when borrowers change their minds about what they want as construction proceeds.

Choose your builder carefully

An important aspect of building your home is choosing the right builder. Find one that has built the kind of house you want in terms of price, style and size. Look into the builder’s credentials with the local homebuilders association and ask for references from previous clients. Check with the Better Business Bureau to see whether there are any complaints against the builder.

Typically, your lender will look into the builder’s credit standing, financial situation and licenses, as well as the track record for building similar homes.

Expect ongoing inspections during construction

Lenders will conduct routine inspections as the home is built. During this period, the lender pays the builder in stages, called “draws,” and usually sends an appraiser or inspector to make sure that construction proceeds as planned.