How Home Construction Loans Work
A construction loan can help you design and build your dream home. However, these loans function differently from traditional mortgages, and they come with some unique qualifying requirements. If you’re considering this type of financing, here’s what you need to know before you commit.
How construction loans work
A construction loan is a short-term financial product that covers the cost of building a residential property from the ground up. This type of financing can cover a wide range of costs associated with the homebuilding process, including:
- Land
- Labor costs
- Material costs
- Permits
Phase 1: Construction and repayment on your construction loan
Repayment terms on these products generally last up to a year, during which time you’ll complete your construction project. Due to the tight time frame, these loans often come with a few more requirements than traditional mortgage loans. For example, you or your housebuilder will need to provide the lender with extra documentation, like a realistic timeline, a complete construction plan and a budget for the build. You’ll also need to regularly update the lender on your progress.
If you go over budget on your home build, you have to cover the extra costs
Phase 2: Convert your construction loan to a permanent mortgage
After the construction phase is complete, it’ll be time to convert your construction loan into a permanent mortgage. Some loans, known as construction-only loans, must be refinanced into a more traditional mortgage product. However, construction-to-permanent loans will automatically convert into permanent mortgages, so you’ll only have to pay one set of mortgage closing costs. We’ll talk about on each of these loan types in more detail below to help you understand which might be best for you.
Learn more about deciding if you should use your homebuilder’s preferred lender.
Home construction loans vs. traditional mortgages
Aside from the various costs that can be included in the loan and the repayment timeline, there are a few major differences between construction loans and traditional mortgages:
- Funds disbursement happens in stages for construction loans. With a traditional mortgage, the funds are disbursed in one lump sum for a home purchase, but they’re distributed in stages for a home construction loan. Each stage is known as a “draw” and the funds for each draw are only disbursed once the previous construction phase has been completed to the lender’s satisfaction.
- The repayment schedule for a home construction loan only requires interest-only payments. Standard residential mortgages require you to start making payments on both the principal and interest of the loan right away. However, with a construction loan, you’ll typically only be responsible for making interest-only payments during the construction period. In addition, you’ll only pay interest on the amount that you’ve borrowed to date.
- Inspections happen at the end of each fund disbursement period for a construction loan. At the end of each draw period, the lender will likely request that a licensed inspector come look at the work completed during that construction phase. As long as everything looks good, the lender will then disburse more funds to the builder so construction can continue. In contrast, inspections for traditional mortgages typically address any specific repairs needed and whether the home is move-in ready. They can also be used as a negotiation point between buyers and sellers.
Read more on what to know about home inspections.Types of construction loans
Construction-only loan
A construction-only loan just covers the cost of building the home. Once the home is constructed, the whole loan amount will typically become due. Borrowers usually cover the balance by paying cash or taking out a new mortgage. However, these loans can often be costlier and more time-consuming, because you’ll have to go through the mortgage process twice and pay two sets of closing costs.
Construction-to-permanent loan
A construction-to-permanent loan transitions from a construction-only loan to a traditional mortgage once the home is built. The loan allows the buyer to complete one round of applications and paperwork and pay one set of closing costs.
Renovation or rehabilitation loan
A renovation loan is a type of construction loan that finances the costs of large improvements to an existing home — adding rooms, a garage or an in-ground swimming pool. Similarly, a rehabilitation loan also finances major changes to a home, but these changes are focused on making the home fit to live in.
Learn more about our picks for the best home improvement loans.
Owner-builder construction loan
If you’re a general contractor or professional builder and you want to build your own home, an owner-builder construction loan could finance your project. With this loan, the homeowner is responsible for acting as the builder and providing the necessary information to the lender to keep the project moving forward.
End loan
An end loan is a type of long-term financing used to pay a builder. In this case, the term “end loan” refers to any type of mortgage that pays off a construction loan. For example, if you took out a construction-only loan and then refinanced into a permanent mortgage once construction was complete, your permanent mortgage might be called an end loan.
Land loan
A land loan only covers the cost of purchasing land that doesn’t have habitable structures on it. The lot may be empty or there may be older structures that don’t have access to all necessary utilities on the land. In either case, you’d need to invest in another type of financing to pay for any construction to the property.
Interested in a land loan? Read our guide on how to get a land loan.
What are some common construction loan requirements?
Unless you get a home construction loan through a government agency, like the Federal Housing Administration (FHA) or the U.S. Department of Veterans Affairs (VA), you’ll typically need to meet conventional mortgage requirements along with some additional qualifications:
- Strong credit score: You’ll generally need a 620 credit score or higher to qualify for a construction loan.
- Reasonable debt-to-income ratio: Your debt-to-income (DTI) ratio measures the percentage of your total income that goes toward paying your existing debts. It tells the lender how easily you’ll be able to manage paying another loan. Conventional lenders typically look for a DTI ratio below 45%.
- Sizable down payment: Construction loans may require a bigger down payment than most traditional mortgages. In some cases, you may be required to put down up to 20%.
- Choice of builder: In addition to all the requirements for a traditional mortgage loan, you’ll also need to show a contract from a licensed builder or contractor.
- Completed construction documents: Your lender will need to approve your construction plans, schedule and project budget.
- Satisfactory home appraisal: Once your home is fully built, it will serve as collateral for your mortgage loan. Lenders will generally require a home appraisal that estimates the completed home’s value so they can be sure they’re making a sensible investment.
Don’t know your credit score? Sign up for LendingTree Spring to get your free credit score today.How to get a construction loan
Here are the basic steps to get a construction loan:
1. Confirm your eligibility for any special program.
If you’re interested in an FHA construction loan or a VA construction loan, check out the requirements and processes for each.
2. Get preapproved.
Before you put a lot of work into finding a builder and designing your home, get a mortgage preapproval so you know how much financing you can qualify for.
3. Find your land and your builder.
Make sure your builder meets any requirements set by your preapproved lender. Pay close attention to licensing and insurance.
4. Complete paperwork.
Finalize the plans with the builder and submit all paperwork to the lender. The lender will likely order an appraisal and inspection.
5. Close on the loan.
The mortgage closing process ends with your signature on the dotted line. After everything is signed and the funds are released, your builder can begin.
Ready to get a construction loan? Get Custom Rates from Top Lenders
Construction loan rates are usually higher than traditional mortgage rates
Interest rates on construction loans tend to be higher than traditional mortgage rates since the lender issues the funds before there’s an asset to secure the loan. If you default on a construction loan, having to repossess a construction site — versus a completed home — is less ideal for the lender. From their view, it’s riskier to lend money for a construction loan, so they charge a higher interest rate to mitigate that risk.
Frequently asked questions
As a rule of thumb, a construction-only loan is likely a good fit for those who have the cash on hand to pay off the loan in full once construction is complete. For example, if you intend to use the proceeds from the sale of another property to repay the loan, you might choose this option.
Construction loans tend to come with much shorter loan terms than traditional mortgages. They typically last for around one year as opposed to the 15- or 30-year terms offered on most residential mortgage loans, which may mean that you’ll need to refinance your loan.
Construction loans also tend to come with higher interest rates, making the project more costly.
Regular mortgage loans are meant to be repaid over a longer period of time than construction loans, which are a type of short-term financing. In addition, construction loans come with more eligibility requirements and higher rates than traditional mortgages.