How do construction loans work?

A construction loan finances building or remodeling a home. Construction loans are typically short-term loans and have higher interest rates than conventional mortgages. Costs eligible for construction loan coverage include land purchase, contractor labor, building materials and permits.

Types of construction loans

When it comes to financing a new build or major remodel, you have a few loan options at your disposal.

The type of loan that’s best for your construction or renovation project will depend on a few factors, including the scope of your project, how you want to pay off the loan and if you wish to take out a mortgage on the home after it’s constructed.

Construction-to-permanent loan

A construction-to-permanent loan serves two purposes: It finances construction and then converts to a mortgage on the home when it’s ready for move-in. Lenders sometimes refer to these loans as “single-close” construction loans. Borrowers pay only one set of closing costs and can choose a variable or fixed rate home loan upon completion of construction or choose to lock in the rate before construction begins.

The mortgage comes from the same lender that finances the construction, which could limit the borrower’s ability to shop around for the best deal. During construction, the borrower makes payments on the interest while receiving funds in phases as construction progresses.

When the house is finished and the loan converts to a permanent mortgage, the monthly payments increase to cover both principal and interest. To qualify for a construction-to-permanent loan, the home must be the buyer’s planned primary residence or second home.

Construction-only loan

As its name suggests, a construction-only loan finances only the construction of a home and does not include mortgage financing for that home once it’s finished. During construction, the borrower makes interest-only payments while the funds are dispersed in phases as building progresses. A construction-only loan is due in full upon completion of the house, or the borrower must shop for additional financing at that time.

Though this loan lets borrowers shop around for the best mortgage deal for their situation, it also means they must go through two sets of applications and two rounds of closing costs, hence the name lenders sometimes use, “two-close” loans. Construction-only loans also tend to have higher interest rates than conventional mortgages.

Renovation loan (home remodel loans)

Renovation loans cover the costs of remodeling a fixer-upper home that you purchase or repairs on the home you currently own. An FHA 203(k) loan, also called a rehab mortgage, finances both the purchase of the home and the rehabilitation. It will also cover just the renovation if you already own the home.

Different from a conventional mortgage, a renovation loan might charge fees to borrowers for the preparation of architectural documents and review of the rehabilitation plan. FHA renovation loans provide a streamlined solution for buyers who want to buy a fixer-upper house and finance repairs to improve the home for living. A renovation loan is based on the projected value of the home once repairs are complete.

Owner-builder construction loan

An owner-builder construction loan lets the borrower serve as the general contractor on the homebuilding project. For borrowers who are experienced homebuilders with proper licenses to oversee the project and ensure code compliance, an owner-builder loan can save money on costs to hire contractors.

End loan

The end loan is the mortgage the borrower takes out to finance the home once it’s built. An end loan can be attained at the same time as a construction-to-permanent loan, or the borrower can shop around for mortgages while the home is under construction.

Construction loan requirements

Since construction loans provide financing for a home that is not yet built, there is no physical house to use as collateral. Because of this, they pose more risk to lenders, which means rates tend to be higher and lenders might require borrowers to meet more strict requirements.

Criteria vary by lender and financial situation. In general, to obtain a construction loan, borrowers should have the following:

• 680 credit score or better
• Debt-to-income ratio no greater than 45%
• Proof of stable income
• A licensed builder
• Construction plan
• Appraisal or projected home value

For an FHA renovation loan, the home must be at least 1 year old and repair costs must exceed $5,000. The property must also fall within the FHA mortgage limit for the area.

Construction loan down payment requirements

In most cases, lenders require a down payment on a construction loan to ensure the borrower is committed to the project. The down payment also protects the lender in case the building does not get completed as planned. A down payment for a construction loan is typically 20% to 30%, higher than a down payment for a conventional or government-backed mortgage.

How to get a construction loan

If you’re ready to apply for a construction loan, follow these steps.

1. Gather your financial information. This includes income, debts, assets and credit history.
2. Talk with a lender. Find out how much you qualify to borrow and which type of construction loan would work best for your situation. Get prequalified if possible.
3. Determine your home building budget. Get estimates from builders with experience in your area and the type of home you want to build. Make sure you have enough cash on hand to cover the down payment and living expenses while your new home is being built. Be prepared for unexpected expenses or construction delays.
4. Hire a licensed contractor to build your new home. Develop a detailed building plan and complete a signed purchase contract that includes the amount the builder will charge, the cost of land (if applicable) and the construction start and completion dates. This is called the “blue book” for your home building project. Be prepared to pay a deposit to the builder.
5. Choose a lender. Look for a lender that is experienced with handling construction loans. Have your land contract and lot deed ready, if applicable.
6. Apply for the construction loan and complete an appraisal. Before the loan closes, you will need to obtain a property appraisal.

Where to get a construction loan

Not all lenders offer construction loans. When shopping for a construction loan, look for lenders that have experience with this type of loan since the process differs from a traditional mortgage.

Local or regional banks might be more willing and able to provide construction loans than national banks because they have an incentive to invest in their own communities and might not have to answer to national investors when taking risks. A construction loan also requires more personal attention, and this is more easily accomplished at a local bank with a branch in your area.

However, some large national banks offer construction loans, and there are also online providers that offer construction financing. A select number of credit unions offer construction loans, commonly construction-to-permanent. The FHA maintains a list of FHA-approved lenders for rehabilitation loans. Fannie Mae and Freddie Mac also have renovation loan programs that are offered through various lenders.

Construction loan rates vary by lender

Construction loans involve more risk for the lender and therefore tend to have higher interest rates than conventional mortgages. Like a traditional mortgage, the interest rate you get on a construction loan varies based on current market rates and borrower qualifications, including credit score, income and the loan amount.

Fees also tend to be higher for construction loans because lenders must review building plans and prepare architectural documents. FHA rehab loans have a 3.5% down payment requirement for qualified borrowers.

Bottom line: Are construction loans worth it?

If you’re looking to build a new home or renovate an existing property, construction loans are a good option. For buyers who want to purchase land and build a home, it could be profitable in a competitive housing market if you know the house will sell for a higher price than it will cost to build. Construction loans also make sense when a buyer has cash on hand to buy land but needs to finance home construction. For landowners whose property is paid off, a construction loan can finance a dream home or an investment property.