How Do Construction Loans Work?

What Is a Construction Loan?

A construction loan enables you to pay all of the upfront costs associated with buying land and building a custom home on it. This includes land, labor, permits and materials. Some construction loans can also be put toward purchasing an existing home to renovate it.

Note that in some situations, new home constructions are financed by the builder or developer. In that situation, you purchase the home from them rather than needing a construction loan.

How Do Construction Loans Work?

Applying for a construction loan is a similar process to a mortgage, though how it actually works is a bit different.

Once you've been approved for a construction loan, your lender typically pays your builder in installments as they complete each phase of construction.

While the home is being built, the only payments you must make go toward the interest. Full payments of the home construction loan start six to 24 months after you take out the loan.

Once the term of the home construction loan ends (normally after 12 months), you must either pay off the entire balance or obtain a traditional mortgage to cover the balance. Depending on the type of construction loan you obtain, it could switch from a construction loan to a permanent mortgage, or you'll have to complete a separate mortgage application process.

Construction Loans vs. Traditional Mortgages

Both construction loans and traditional mortgages provide a way to finance large property purchases, typically starting in the six figures. There are some important differences between the two, though:

• Construction loans are short-term, with terms often at just one year. Mortgage loans, on the other hand, are long-term and usually repaid over 15 or 30 years.
• Mortgage payments go toward both interest and principal (plus other costs, like property taxes and homeowners insurance). Construction loan payments are typically interest-only during the building process.
• A home construction loan typically carries stiffer requirements than a traditional mortgage loan since lenders don't have a property to serve as collateral should the borrower default. This includes requiring a down payment of 20% or more, while many conventional and government-backed loans allow for far less upfront.
• Another consequence of construction loans being riskier to lenders: Interest rates are higher than most traditional mortgages.

Learn more: How to Get a Mortgage

What Does a Construction Loan Cover?

What's covered by a construction loan depends on the type of loan and your lender, but it can likely cover expenses such as:

• Cost of the land or lot
• Building materials
• Contractor labor
• Plans, permits and related fees
• Closing costs

Keep in mind that construction loans don't pay for your living expenses while your new home is under construction. That means you'll be paying this loan while also paying for your existing mortgage or lease, or temporary housing, until you can move in. While you can use the proceeds of selling your home to make a down payment on a construction loan, make sure you can afford to live elsewhere while the new house is built.

Types of Construction Loans

Construction loans are available in a few different forms:

• Construction-to-permanent loan: This loan mixes construction financing with conventional mortgage financing. During the home's construction phase, your payments are interest-only. Once building is complete, the loan converts to a normal mortgage loan, and your payments will start paying off the principal balance. They can be much costlier than traditional mortgages, but they save you the headache of taking out multiple loans.
• Construction-only loan: This short-term loan is usually just for a year and meant to only cover the construction process. It must be paid off by the term's brief end, and borrowers must then apply for a traditional mortgage (and pay more loan fees). Most lenders no longer provide this kind of loan since it's high-risk for them.
• End loan: If you had to take out a short-term loan to cover construction, but it doesn't convert into a mortgage, an end loan can be a solution. This is a long-term, permanent loan you take out once construction is finished, and it can be used to pay off your construction loan over time.
• Owner-builder construction loan: If you're savvy with homebuilding and plan to be your own general contractor, some lenders offer these loans specifically for that situation. Just know that before handing over the money, lenders will expect proof you have the licensure, experience and/or training to do the job.
• Renovation loan: There are a few types of renovation loans, which can help you either buy and renovate a fixer-upper or pay for a major home overhaul on your existing house. The government-backed Federal Housing Authority (FHA) 203(k) loan lets you buy and renovate a home and make one monthly payment for all of the costs. Fannie Mae and Freddie Mac also have renovation loan options.

Construction Loan Requirements

Requirements for a home construction loan may include:

• Solid credit score, typically a minimum of 620
• Down payment, usually 20%
• Substantial amount of savings
• Low debt-to-income ratio, which compares your monthly debt obligations with the amount of money you earn
• Signed contract with licensed builder
• Detailed construction plans

How to Get a Construction Loan

The process of getting a construction loan has similarities to obtaining a regular mortgage, with some key differences. Here's what the process typically looks like:

1. Find a homebuilder. When applying for a construction loan, you'll need to already have a building budget and plan, so choose your builder first. Given the cost of building—and the cost of fixing shoddy work later—do plenty of research to find an experienced, qualified builder. Ask friends for recommendations, read reviews, look at examples of their work and confirm their credentials before you make your pick and sign a contract.
2. Round up your documentation. In addition to typical mortgage paperwork, like proof of income and assets, prepare to hand over documents detailing your planned build. This includes providing a signed contract from the builder or developer, complete with plans, specifications and timeline. The lender will also likely need the builder to submit documentation, including their insurance, license and financial statements.
3. Compare and choose a lender. Now it's time to shop around and get preapproved with several lenders to compare quotes, since interest rates, fees and terms can vary.
4. Get approved and get started. Your chosen lender will review all of your documentation, and if it approves you, it determines how much to lend you. Once you've signed a loan agreement, your lender will begin disbursing money to your builder according to the project schedule.

Frequently Asked Questions

The Bottom Line

Since construction loans usually have stricter borrowing criteria than traditional mortgages, having strong credit can increase your chances of approval—and for landing the lowest interest rate possible. Before applying for a construction loan, take steps to get your credit lender-ready, and check your free credit report and score from Experian to track your progress.