Construction Loans: What They Are & How They Work

Written by Elijah BishopUpdated: 31st Mar 2022
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Finding the perfect house that meets all your housing expectations can be challenging. With so many house designs and styles to choose from, it is unsurprising for individuals not to know where to start their search.

And if you like many individuals who have a set-in-stone house style in mind, then there are a whole lot of factors you must consider.

For many individuals, there are certain must-haves they want in their future homes. Maybe you want a house close to the highway, a minimum of three-bedroom with walk-in closets, or an attached four-car garage; the choices are numerous.

With all of these needs and wants going through your mind coupled with the limited inventory of houses in the market, finding a house that meets even half of your housing desires and budget is near impossible.

During your house hunting, you’ll often find homes that match some of your wants, but it is impossible to find a house that meets all your must-haves. This forces you to compromise on some of your must-haves to move ahead in the homeownership journey.

Don’t feel like compromising on your housing must-haves? Then don’t, because if your perfect home is not available for sale in the market, you can have it built to your specification. But the problem is that building a house is pretty expensive.

You have to pay for the land, pay the architect, pay the builder, pay for permits, and pay for just everything. This is one of the reasons why taking out a home construction loan can be your best bet.

Keep reading to learn more about home construction loans and how they work. So here we go.

What Is a Construction Loan?

A construction loan is a short-term, higher interest loan that covers the cost of building or rehabilitating a residential property.

Construction loans are typically for less than a year, and the funds are paid out in a series of installments, known as “draws”, while the home is being built.

Once the home is built, construction loans are usually refinanced or converted into a traditional long-term mortgageto pay for the house.

So, if you’re unable to find a house that matches your housing expectations and wants to build one from the ground up but doesn’t have the required funds, a construction loan will likely be your best option.

How Do Construction Loans Work?

Compared to other mortgage loans, construction loans are pretty complex and require a proper understanding of the process to avoid costly financial mistakes.

You will need to have a ready and realistic architectural plan with construction loans before applying for a construction loan.

Just like with other loan types, to be approved for a construction loan, you’ll need to go through the usual hoops of proving your creditworthiness and financial worthiness.

Your lender will also request that you present a detailed blueprint of your potential home and the building cost.

Construction loan lenders often need to verify and approve the building company you have chosen for your home construction.

Once you’ve tendered the required information and your construction loans have been approved, your chosen builder and not you will receive the first disbursement of the funds.

Unlike traditional mortgage loans, you do not receive the funds in a lump sum. Instead, your builder receives series of disbursements of the funds called a ‘draw’ for each stage of the project.

So, whenever your builder requests a draw for a new project phase, an inspector sent by the lender will visit the site to check the work progress.

More importantly, the draw schedule is determined by the lender. So, you and your builder must understand the lenders’ draw schedule before breaking ground.

In addition, during the building process, you’ll only need to make interest-only payments on the loan disbursed.

Types of Construction Loans

Building a home comes with its share of variations. Every potential homeowner has a different building goal in mind.

To meet the varying building expectations of future homeowners, there are several types of construction loans. Below are the different types of construction loans and their offerings.

Construction-To-Permanent Loan

A construction-to-permanent loan is a type of construction that automatically converts to a permanent mortgage once the building is completed.

With a construction-to-permanent loan, you only have to complete one mortgage application and close the loan once. And you’ll only have to pay closing costs once.

More importantly, during the home construction process, you’ll only make interest-only payments and then start paying down the principal and interest once it converts to a traditional permanent mortgage. At this point, you may decide to opt for a fixed-rate or adjustable-rate mortgage.

Construction-Only Loans

This is a type of construction loan less traveled by potential homeowners. A construction-only loan provides the necessary financing to complete the building of the home.

Still, 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.

If you decide to obtain or refinance to a permanent mortgage, you’ll have to undergo two mortgage applications and closings, each with its closing costs.

A construction-only loan is excellent for individuals who have a large amount of cash on hand or intend to pay off the cost of the construction loan with the sale of their previous of their existing home.

In addition, a construction-only loan can be costlier due to the number of closing costs you will need to pay.

>> More: How to Get Mortgage Preapproval

Renovation Construction Loans

If you plan to renovate your existing home instead of building a new one, a renovation construction loan is your best bet.

One of these types of loans is the FHA 203(k). Insured by the Federal Housing Administration (FHA), this loan type gives homeowners money to purchase a home and extra money to carry out the necessary renovations.

Like a typical construction loan, the amount of money you can borrow will entirely depend on an appraiser’s estimated value of your home once the rehab is completed.

And your lender will still want to see your renovation plans, approve your builder, and release the money in draws.

While there are other excellent renovation loan options like taking out a personal loan, cash-out refinances, and home equity line of credit (HELOC), the benefit of financing your home renovation with a construction loan is that it provides you with a lower interest rate and a more extended repayment period.

Owner-Builder Loan

Owner-builder loans are either construction-only or construction-to-permanent loans where the borrower seeks to act in the capacity of the home builder.

It is uncommon for lenders to allow borrowers to act in the stead of the home builder due to the complexities of building a home.

Even lenders that do only allow it if the borrower is a licensed builder or has verifiable experience in building homes.

End loan

An end loan is a traditional mortgage that you can apply for after the construction of your new home is completed.

It is just another term for the mortgage loan that a borrower uses to pay off their construction loan.

Construction Loan Interest Rates

Like the interest rates for other types of traditional mortgage loans, construction loan interest rates vary based on a borrower’s credit score, debt-to-income ratio, loan amount, and loan term.

Also, the interest rates a borrower receives differ across the best mortgage lenders. That is why we encourage our readers to shop around lenders before settling for a loan offer.

Generally, you should find construction loan interest rates between 3.25% and 4%. It is a known fact that construction loan interest rates typically hover around one percentage point above standard mortgage loan rates.

And since there is no collateral to back construction loans, these types of loans are expected to have some of the highest interest rates.

>> More: How Are Mortgage Rates Determined?

Construction Loan Requirements: How to Qualify

Before you can get the necessary funding for your new home construction, you’ll need to get approved for one.

And as with other types of mortgage loans, you’ll need to meet the necessary lending requirements to qualify for a construction loan. Below are some of the basic construction loan requirements.

Good Credit

Like with other mortgage loan options, your credit score and history are significant to lenders.

Most online mortgage lenders will require that you have a credit score of at least 680 or higher to qualify for a construction loan. However, others may request a score of at least 700.

Low Debt-to-Income Ratio

Your DTI ratio compares all your monthly debt payments in relation to your gross monthly income.

The higher your DTI ratio, the lesser the amount of cash you have to pay for your monthly construction loan payments.

To increase your chances of approval, you should lower your DTI ratio before applying. More importantly, most lenders require a DTI ratio of 45% or less.

Solid Income

Aside from having a good credit score, most lenders will expect that you have enough income to cover the necessary payments on your current debts and construction loan.

To prove this, your lender will request to see copies of your financial statements, pay stubs, and employment history.

Can Meet Down Payment

Most lenders will require a 20% – 30% down payment for a new construction loan. This down payment requirement varies across lenders, but you may have to deal with mortgage insurance if you make a down payment of less than 20%.

Project Approval

Due to the complexities of building projects, lenders want to see enough details about the potential building construction before approving your loan.

You can quickly increase your chance of approval by providing your lender with documents such as a deed of the land, building designs, cost estimates, a draw schedule, and a signed purchase order.

General Contractor Approval

Lenders love to play on the safer side, and this also applies when they are giving out a construction loan.

Before you’re approved for a construction loan, your will need solid documentation that proves that your architect and builder are licensed, insured, and have the necessary qualifications.

What Is the Required Down Payment for a Construction Loan?

While there is no standard down payment requirement for a construction loan across lenders, most lenders will require a 20% – 30% down payment for a new construction loan.

The down payment requirement is a bit stringent because there is no collateral to back the loan or protect the lender.

How to Choose a Construction Loan Lender

When choosing a construction loan lender, there is a lot to consider, making the process quite challenging.

For that reason, it can be tempting to accept the first lender and offer that comes your way. In choosing a construction loan lender, you should consider the following questions to guide your decision.

  • What types of construction loans do you offer?
  • What interest rates are available? Are they fixed or variable?
  • Do you charge closing costs or other fees?
  • Can I use the equity I have in my land toward a down payment?
  • How do you pay construction draws—as a percentage of completion or based on a set schedule?
  • Can the builder request the first draw to pay for materials?

Since construction loans are more complex than traditional mortgage loans, you must choose a local lender specializing in construction loans.

In addition, if you have any trouble finding a suitable lender, you should consider reaching out to smaller regional banks or credit unions for assistance.

Do Construction Loans Cover the Design Phase Construction?

The short answer is a No. Construction loans do not cover the design phase of the construction.

Before applying for a construction loan, you are expected to finance the cost of the building architectural designs out of pocket.

This is because most construction loan lenders expect to see readily available designs of the potential construction by the time you apply for the loan.

>> More: Learn How to Choose the Best Mortgage

Is It Hard to Get a Construction Loan?

It is harder to get a construction loan compared to a traditional mortgage loan. One of the reasons is that most lenders consider this type of loan as a risk since there is no collateral to back the loan.

To save lenders from the huge risks, it is common for construction loans to come with higher down payment requirements and interest rates compared to traditional mortgage loans.

Bottom Line: What Is a Construction Loan?

Building a house can be a challenging undertaking, so it is essential that you are well-equipped and financially prepared before embarking on it.

Getting a construction loan can be your best bet if you need external financing to cover the cost of your new home construction.

Before applying for a construction loan, you should shop across lenders to find the best loan terms and interest rates.

More importantly, it would help if you considered speaking to an experienced mortgage advisor for professional guidance on whether or not a construction loan is the right option for your situation.

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Elijah Bishop
Elijah Bishop

Elijah A. Bishop is a Senior Personal Finance Writer who has been writing about real estate and mortgages for years. He has a Bachelors of Arts Degree in Creative writing from Georgia State University and has also attended the Climer School of Real Estate. He also holds a realtor license and has been in and out of the US mortgage industry as a loan officer. Bringing over 15 years of experience, Elijah produces content that analyzes ethnicities, race, and financial well-being. His areas of expertise are mortgages, real estate, and personal loans.