What are construction
loans and how do they work?
What is a construction loan?
A home construction loan is a short-term, higher-interest loan that provides the funds required to build a residential property.
Construction loans typically are one year in duration. During this time, the property must be built and a certificate of occupancy should be issued.
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How do construction loans work?
Construction loans usually have variable rates that move up and down with the prime rate. Construction loan rates are typically higher than traditional mortgage loan rates.
With a traditional mortgage, your home acts as collateral — if you default on your payments, the lender can seize your home.
With a home construction loan, the lender doesn’t have that option, so they tend to view these loans as bigger risks.
Because construction loans are on such a short timetable and they’re dependent on the completion of the project, you need to provide the lender with a construction timeline, detailed plans and a realistic budget.
Once approved, the borrower will be put on a draft or draw schedule that follows the project’s construction stages, and will typically be expected to make only interest payments during the construction stage.
Unlike personal loans that make a lump-sum payment, the lender pays out the money in stages as work on the new home progresses.
These draws tend to happen when major milestones are completed — for example, when the foundation is laid or the framing of the house begins.
Borrowers are typically only obligated to repay interest on any funds drawn to date until construction is completed.
While the home is being built, the lender has an appraiser or inspector check the house during the various stages of construction.
If approved by the appraiser, the lender makes additional payments to the contractor, known as draws. Expect to have between four and six inspections to monitor the progress.
Depending on the type of construction loan, the borrower might be able to convert the construction loan to a traditional mortgage once the home is built.
This is known as a construction-to-permanent loan. If the loan is solely for the construction phase, the borrower might be required to get a separate mortgage designed to pay off the construction loan.
What does a construction loan cover?
Some things a construction loan can be used to cover include:
- The cost of the land
- Contractor labor
- Building materials
- Permits
While items like home furnishings generally are not covered within a construction loan, permanent fixtures like appliances and landscaping can be included.
It’s important to discuss these items with your lender, specifically what will be included in your loan-to-value calculation, according to Steve Kaminski, head of U.S. residential lending at TD Bank.
“Oftentimes, construction loans will include a contingency reserve to cover unexpected costs that could arise during construction, which also serves as a cushion in case the borrower decides to make any upgrades once the construction begins,” Kaminski says.
“It’s not uncommon for a borrower to want to elevate their countertops or cabinets once the plans are laid out.”
Types of construction loans
Construction-to-permanent loan
With a construction-to-permanent loan, you borrow money to pay for the cost of building your home, and once the house is complete and you move in, the loan is converted to a permanent mortgage.
The benefit of the construction-to-permanent approach is that you have only one set of closing costs to pay, reducing your overall fees.
“There’s a one-time closing so you don’t pay duplicate settlement fees,” says Janet Bossi, senior vice president at OceanFirst Bank in New Jersey.
Once the construction-to-permanent shift happens, the loan becomes a traditional mortgage, typically with a loan term of 15 to 30 years.
Then, you make payments that cover both interest and the principal. At that time, you can opt for a fixed-rate or adjustable-rate mortgage.
Your other options include an FHA construction-to-permanent loan — with less-stringent approval standards that can be especially helpful for some borrowers — or a VA construction loan if you’re an eligible veteran.
Construction-only loan
A construction-only loan provides the funds necessary to complete the building of the home, but the borrower is responsible for either paying the loan in full at maturity (typically one year or less) or obtaining a mortgage to secure permanent financing.
The funds from these construction loans are disbursed based upon the percentage of the project completed, and the borrower is only responsible for interest payments on the money drawn.
Construction-only loans can ultimately be costlier if you will need a permanent mortgage because you complete two separate loan transactions and pay two sets of fees. Closing costs tend to equal thousands of dollars, so it helps to avoid another set.
Another consideration is that your financial situation might worsen during the construction process.
If you lose your job or face some other hardship, you might not be able to qualify for a mortgage later on — and might not be able to move into your new house.
Renovation loan
If you want to upgrade an existing home rather than build one, you can compare home renovation loan options.
These come in a variety of forms depending on the amount of money you’re spending on the project.
“If a homeowner is looking to spend less than $20,000, they could consider getting a personal loan or using a credit card to finance the renovation,” Kaminski says. “For renovations starting at $25,000 or so, a home equity loan or line of credit may be appropriate, if the homeowner has built up equity in their home.”
Another viable option in the current low mortgage rate environment is a cash-out refinance, whereby a homeowner would take out a new mortgage at a higher amount than their current loan and receive that overage in a lump sum.
With any of these options, the lender generally does not require disclosure of how the homeowner will use the funds. The homeowner manages the budget, the plan and the payments. With other forms of financing, the lender will evaluate the builder, review the budget and oversee the draw schedule.
Owner-builder construction loan
Owner-builder loans are construction-to-permanent or construction-only loans where the borrower also acts in the capacity of the home builder.
Most lenders won’t allow the borrower to act as their own builder because of the complexity of constructing a home and experience required to comply with building codes.
Lenders that do typically only allow it if the borrower is a licensed builder by trade.
End loan
An end loan simply refers to the homeowner’s mortgage once the property is built, Kaminski explains. A construction loan is used during the building phase and is repaid once the construction is completed.
A borrower will then have their regular mortgage to pay off, also known as the end loan.
“Not all lenders offer a construction-to-permanent loan, which involves a single loan closing. Some require a second closing to move into the permanent mortgage, or an end loan,” Kaminski says.
Construction loan requirements
To get a construction loan, you’ll need a good credit score, low debt-to-income ratio and a way to prove sufficient income to repay the loan.
You also need to make a down payment when you apply for the loan. The amount will depend on the lender you choose and the amount you’re trying to borrow to pay for construction.
Many lenders also want to make sure you have a plan. If you have a detailed plan, especially if it was put together by the construction company you’re going to work with, it can help lenders feel more confident you’ll be able to repay the loan.
Adding an appraisal estimating how much the finished home will be worth is also helpful.
The home will serve as collateral for the loan, so lenders want to make sure the collateral will be sufficient to secure the loan.
How to get a construction loan
Getting approval for a construction loan might seem similar to the process of obtaining a mortgage, but getting approved to break ground on a brand-new home is a bit more complicated.
Steps to get a construction loan
- Find a licensed builder: Any lender is going to want to know that the builder in charge of the project has the expertise to complete the home. If you have friends who have built their own homes, ask for recommendations.
- You can also turn to the NAHB’s directory of local home builders’ associationsto find contractors in your area. Just as you would compare multiple existing homes before buying one, it’s wise to compare different builders to find the combination of price and expertise that fits your needs.
- Get your documents together: A lender will likely ask for a contract with your builder that includes detailed pricing and plans for the project. Be sure to have references for your builder and any necessary proof of their business credentials.
- Get preapproved: Getting preapproved for a construction loan can provide a helpful understanding of how much you will be able to borrow for the project.
- This can be an important step to avoid paying for plans from an architect or drawing up blueprints for a home that you will not be able to afford.
Factors to consider about construction loans
Before you apply for a construction loan, ask yourself these key questions.
Could your project face significant timeline issues?
Talk to your contractor and discuss the timeline of building the home and if other factors could slow down the job.
One of the biggest challenges facing construction projects right now is a shortage of materials.
According to a May 2021 survey by the National Association of Home Builders, more than 90% of builders have encountered shortages of appliances, lumber and oriented strand board, a type of engineered wood used in flooring, walls and more.
Other essential materials have been hard to find: 87 percent of builders had issues getting windows and doors.
Do you want to simplify the borrowing experience?
Decide if you want to go through the loan process once with a construction-to-permanent loan or twice with a construction-only loan. Consider how much the closing costs and other fees of obtaining more than one loan will add to the project.
When getting a construction loan, you’re not just accounting for building the house; you also need to purchase the land and figure out how to handle the total cost later, perhaps with a permanent mortgage when the home is finished.
In that case, a construction-to-permanent loan can make sense in order to avoid multiple closings.
If you already have a home, though, you might be able to use the proceeds to pay down the loan. In that case, a construction-only loan might be a better choice.
Do you have homeowners’ insurance in place?
Even though you don’t live in the home yet, your lender will likely require a prepaid homeowners insurance policy that includes builder’s risk coverage.
This way, if something happens during the construction process — the halfway-built property catches on fire, or someone vandalizes it, for example — you are protected.
How to find a construction loan lender
Check with several experienced construction loan lenders to obtain details about their specific programs and procedures, and compare construction loan rates, terms and down payment requirements to ensure you’re getting the best possible deal for your situation.
“Because construction loans are more complex transactions than a standard mortgage, it is best to find a lender who specializes in construction lending and isn’t new to the process,” Bossi says.
If you have trouble finding a lender willing to work with you, check out smaller regional banks or credit unions.
They might be more flexible in their underwriting if you can show that you’re a good risk, or, at the very least, have a connection they can refer you to.