What is a Construction Loan?

A construction loan allows you to finance building a new residential home. You can use this loan to cover different stages of the construction process, from purchasing a plot you’ve had your eye on to adding finishing touches. We’ll explain how construction loans work, the different types you can choose from, and some pros and cons to help you make the right decision for your wallet.

How does a construction loan work?

A construction loan is a short-term loan — usually less than a year — to help cover the cost of building a new house. You’ll typically receive funds at different stages of your building project. Once construction wraps up, you can either pay off the loan in full or transition to a conventional mortgage loan.¹

Typical requirements for a construction loan

Construction loans come with a few extra hoops to jump through compared to a traditional mortgage. That’s because lenders are taking a bigger risk by financing a home that doesn’t exist yet. Here’s what lenders usually want to see before they approve your application:²

• Good credit history: Lenders want to see that you handle your credit responsibly. While every lender has different standards, a strong track record could help you qualify for a favorable interest rate and better loan terms.
• A manageable debt-to-income ratio: Your debt-to-income ratio (DTI) is how much of your monthly income goes toward debt payments. If too much of your income is already tied up in other loans or credit card bills, getting approved for a construction loan might be more difficult.
• A detailed construction plan and budget: Also known as a “bluebook” or “construction binder,” this includes timelines, estimated costs, building materials, permits and more.
• A down payment: Construction loans usually require at least a 20% downpayment,³ but it may vary depending on the lender and the amount you borrow.
• A licensed, experienced builder: Most lenders won’t approve a loan unless you work with a licensed builder. If you’re hoping to build the home yourself, you’ll typically need to be a licensed contractor.
• Proof of homeowner’s insurance: You’ll likely need homeowners insurance lined up before closing⁴ and, in some cases, additional insurance that covers the construction phase to protect the property while it’s being built.

Loan distribution

The funds from your loan are distributed while construction progresses through the different stages of building your house. For example, you might draw money to build the frame or to lay down the flooring.

Loan repayment

During construction, you will usually only need to pay interest (the cost of borrowing) on the funds you’ve used. Once you have finished building the home, you will be required to pay the principal (the original loan amount) plus interest.

Types of construction loans

Understanding the different types of construction loans is important to making the best decision for your budget and future goals.

Construction-to-permanent loan

A construction-to-permanent loan transitions from a construction loan to a conventional mortgage once the construction is complete, and you move into the home. It’s beneficial to have all your building costs converted into a monthly mortgage payment — with a 15- to 30-year term⁵ — that you can repay over time rather than pay everything upfront.

Construction-only loan

With a construction-only loan, you’ll receive the funds you need to complete the construction, but you will be required to repay the total cost of the loan within the term, which is usually about a year. If you’re unable to repay the construction-only loan in full, you can apply for a mortgage to roll the costs over into a new loan. You might get a better rate with this new mortgage than you would with the construction-to-permanent loan, but keep in mind that you may have to pay the closing costs and fees for two separate loans (the construction loan and the mortgage).

Owner-builder construction loan

With an owner-builder construction loan, the borrower also acts as the builder, which is why lenders usually approve these loans only if the borrower is a licensed contractor. Lenders do not typically offer this type of loan to non-licensed borrowers.

End loan

An end loan is also known as a mortgage. Once the construction is complete, you’ll take out a mortgage to repay the costs of building your home. You will also be responsible for paying closing costs and any additional fees associated with the end loan/mortgage.

Pros and cons of construction loans

Making long-term financial decisions isn’t always easy. It helps to weigh the pros and cons to make sure your next steps make sense for your budget and end goals.

Pros

• Versatility: Construction loans can cover many different costs, from purchasing land and building materials to labor costs and landscaping
• Interest-only payments (while you build): You only pay interest on the funds you receive during each building phase.
• Custom-built homes: You get to design a home that fits your needs and lifestyle.

Cons

• Higher closing costs: You could pay an additional set of closing costs if you convert your construction loan to a mortgage. (If you keep your loan as is, you only pay closing costs once.)
• Funds are released gradually, not all at once: Lenders may require a draw inspection to verify the progress on your home before releasing each phase of funds. Waiting for each inspection to be completed (and for the lender to review it) may impact your timeline.
• Higher interest rate: Construction loans typically have higher interest rates than a conventional mortgage.⁶ The rates could be higher because there is no collateral (something valuable that you possess) to back your loan, since your house is still being built.

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Build your financial future, brick by brick

Building your dream home from the ground up can be incredibly rewarding, but it requires managing a lot of moving parts — and the right financing. Whether you’re hiring a builder or taking on the role yourself, understanding how construction loans work can help you avoid surprises and stay on budget. As with any major financial decision, be sure to compare your options, ask plenty of questions, and choose a loan that fits your goals both during and after construction.

Sources

1 https://www.consumerfinance.gov/ask-cfpb/what-is-a-construction-loan-en-108/
2, 3 https://www.rocketmortgage.com/learn/construction-loans
4, 5, 6 https://www.bankrate.com/mortgages/construction-loans-explained/#types-of-loans