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 thinking of investing in this type of financing, here’s what you need to know before signing on the dotted line.

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

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.

In cases where the construction costs go over budget, it’s often up to the homeowner to cover the difference, either by altering the project scope or paying out of pocket.

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 closing costs. (More on each of these loan types below.)

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: 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.
• Repayment schedule: 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: 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.

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 a dilapidated home fit to live in.

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 type, the homeowner is responsible for acting as the builder and providing the lender with the necessary information 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.

If you’re interested in more information, here’s 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:

• 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.

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.

Important FYI about construction loan rates

Interest rates on construction loans tend to be higher than those for traditional mortgages, as 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.