Choosing new construction is a great way to get exactly what you want in a home. You can choose the plot of land, the layout, and even the finishes used. The home will be built custom just for you, based on your wants and needs.
But building your own home can also come with nuances. Namely? You’ll often need to use a construction loan to finance them.
Unlike existing home purchases, a new home build requires money to cover materials, labor, and other upfront costs. That’s where a construction loan comes in.
Are you considering building a home? Here’s what you need to know about construction loans.
What is a construction loan?
A construction loan is a type of short-term loan. You take one out to finance the upfront costs of building a home, and then, once the home is finalized, you pay it off with another loan — typically a mortgage.
With a construction loan, you’ll usually need a hefty down payment of at least 20% (in most cases) and you can expect to see higher interest rates than you’d see on a traditional mortgage. This is mainly due to these types of loans being riskier for lenders to fund, since they do not require collateral.
A mortgage loan, for example, is secured by the house; a construction loan isn’t secured by any asset. This makes it harder for lenders to recoup their losses if you fail to make payments.
Types of construction loans
There are several types of construction loans, including:
- Construction-only loans. These only cover the cost of constructing and building your property. They must be paid off once the home is finished — usually within a year.
- Construction-to-permanent loans. These loans start as short-term construction loans and then convert into a long-term mortgage once the home is finished.
- Renovation loans. Renovation loans are designed for purchasing and updating a home in one fell swoop. The FHA 203(k) mortgage is a good example of this type of loan.
- Owner builder loans. These loans allow you to act as your own builder and finance the construction of your property. If you’re an experienced contractor, this might be an option for you.
- End loans. An end loan is a long-term mortgage that you’ll need to apply for once your home is constructed.
How construction loans work
Construction loans can come with fixed or adjustable interest rates and operate much like a credit card. They come with a line of credit, and you can draw on those funds as needed throughout your home’s construction.
The nice thing about this approach is that you only pay interest on what you’ve borrowed so far. So if you’ve only taken $10,000 from your construction loan this month, that’s all you’ll pay interest on. You won’t pay interest on the rest of your line of credit until you’ve withdrawn those funds.
As for retrieving the funds, the lender will release funds via a draw schedule — basically a disbursement plan set by your builder — and pay either you or your contractors/builders directly. The lender will require an inspection to confirm any work done before disbursing the money.
What can a construction loan pay for?
You can use a construction loan to pay for virtually all of your home’s construction, including:
- Services performed by architects and planners.
- The land you build on.
- Closing costs.
If you already own a home, you might also be able to use a construction loan to pay for renovations, though there are other options for financing these updates, too. For instance, a home equity loan, cash-out refinance, or home equity line of credit may be a better fit, depending on how much equity you have in your property.
Qualifying for a construction loan
Lenders are often quite strict about who they’ll offer a construction loan due to their added risk. They might require a thorough evaluation of your architectural/construction plans, your chosen builder or contractor, and your financial situation. You will usually need decent credit and a large down payment in order to qualify.
Here’s a look at some general qualifications you’ll need to meet to get a construction loan. Keep in mind that these vary by lender:
- Down payment: 20% or more.
- Credit score: 620.
- Debt-to-income ratio: 45% or less.
When you apply for your loan, you’ll need a signed sales contract with a builder. Your builder will also need to provide documentation, including copies of their license and insurance.
What happens after the home is built?
While your home is being built, you’ll usually only pay the interest on the funds you’ve withdrawn. Once construction is complete, you’ll pay off the rest of the balance with a more permanent mortgage loan.
There are two ways to go about this:
- You can apply for your new mortgage loan as you approach the end of construction. Keep in mind that you’ll need to meet the lender’s credit score, debt-to-income ratio, down payment, and other requirements, so make sure you’re prepared. Once approved, your new loan can be used to pay off your construction loan, and you’ll begin making payments on your mortgage the next month.
- You can choose what’s called a construction-to-permanent loan from the start. These are technically two loans, which you’ll apply for with one single application and lender. Your lender will first finance the construction process, and then, once all is said and done, pay that off with a traditional mortgage loan — typically a 15- or 30-year one.
Just a heads up: not all lenders offer these two-for-one loans, so make sure you do a thorough search if you’re considering this option.
Pros and cons of construction loans
- Small, interest-only payments while you’re building your home. Since you’ll be paying to live somewhere else while your home is being built, this can make things a bit more affordable.
- You may be able to finance your build and transition into a permanent mortgage loan with one single application — and one single closing. This can also save you on closing costs.
- Can be used to cover all aspects of your home’s build. This includes the land you’re building on and other costs that come with your construction.
- Can be harder to qualify for than other types of loans. They require large down payments, good credit, and thorough construction plans.
- May come with higher interest rates. These loans are riskier for lenders than other mortgage options. As a result, they often come with higher rates.
- Can be tedious. With most lenders, you’ll need to have each job inspected before you can withdraw funds. This can make for a time-consuming and taxing process.
- May require two loan applications and two sets of closing costs. If you’re unable to qualify for a construction-to-permanent loan, you’ll need to take out two separate loans (and pay closing costs twice).
Where to get a construction loan
If you’re set on using a construction loan to build your dream home, then start shopping around for lenders now. For one, not all lenders offer these loans. More importantly, shopping around can ensure you get the best rates and terms possible.
Here are some places you can start:
- Your local bank or credit union. They may have a construction loan program, and you might enjoy loyalty perks for using your home bank.
- Your builder. They may have recommendations for local lenders in your area.
- Loan marketplaces. Loan marketplaces like Fiona and Monevo can help you find and compare loan terms within minutes. Simply answer a few questions and you’ll have a list of top-tier providers at your disposal.
- A mortgage broker. Mortgage brokers are like personal shoppers for loans. A local broker should have recommendations for construction lenders in your area.
When you contact a loan officer, just ask if they offer construction loans, and if so, what type. Remember that construction-to-permanent loans will save you money on closing costs and remove the need for a second loan application later on.
If you’re hoping to build your dream home from the ground up, you’ll likely need a construction loan to do it. These loans require large down payments and often come with higher interest rates than other types of loans.
You also may need to apply for a second loan — a permanent mortgage — once your home is built.