Building a home instead of buying? What to know about construction loans

Construction loans finance the building of a new home. (Shutterstock)

Building a new home can offer a wealth of benefits. You can choose the layout that suits your family perfectly, and with a style that makes your home feel like yours from day one. 

But the process can be challenging, especially when it comes to financing. You’ll likely need a construction loan, which works differently than a traditional mortgage. Lining up your construction loan before breaking ground can make your home build go much more smoothly. Let’s look at how a construction loan works and how to get one.

While you might turn to a construction loan to build a house, a personal loan can be a good option for funding other home projects, including renovations and additions. 

• What is a construction loan and how does it work?
• Different types of construction loans
• What costs can I pay for with a construction loan?
• What are the interest rates on construction loans?
• How can I get a construction loan?
• Alternatives to construction loans

What is a construction loan and how does it work?

A construction loan is a special type of financing that covers the cost of building a new residential home. It works differently than a mortgage loan. Construction loans are more like personal loans — they’re usually short-term and at higher interest rates because of the additional risk to the lender. If you fail to make your payments, a partially built home is difficult to sell after foreclosure.

Unlike personal loans or mortgages, construction loan funds aren’t disbursed all at once. Instead, you or your contractor will be able to draw from the loan in stages as construction progresses. During construction, you’ll typically make interest-only payments on the loan. You may begin making your payments on the loan six months to two years after the loan closes, depending on your build’s timeline. At the end of the home’s construction, the loan typically converts to a traditional mortgage — though you may need to pay off the construction loan in a lump sum.

Construction loan draw schedule

The process of disbursing construction loan funds is known as a draw schedule. Before closing, both you and the homebuilder will sign an agreement that outlines how the draw schedule will work, usually corresponding with different phases of construction. Your builder can request to draw from the construction loan as work is completed and inspected. 

Typically, you can’t make the final draw until construction is complete and the local government issues a certificate of occupancy. A lender may charge a penalty fee if your home takes longer than expected to build.

Different types of construction loans

The construction loan that works best for your new home build depends on your situation. A few variables will help determine the type of loan you choose. These can include the project you have in mind, who’s doing the work, and how the overall market is moving. 

Construction-to-permanent loan

Construction-to-permanent loans begin as a construction loan to pay for the costs of the build, then convert to permanent financing once you’re ready to move in. You generally close one time on the loan and pay one set of closing costs, making it more convenient and cost-effective. You can also typically lock in an interest rate, making this a good option if rates are rising. 

Construction-only loan

These loans cover only the construction phase of the project. You can pay off the loan in a lump sum at the end of the build, or you can take out a traditional mortgage. 

If interest rates are falling, you may choose this option to get a lower rate on your permanent mortgage. You may also go this route if you want to shop around for a mortgage after construction rather than sticking with a particular construction-to-permanent loan program. However, in many cases, applying for two different loans will add to your costs and your risk.

Owner-builder construction loan

Many construction loans require you to work with a home builder or general contractor on your project. If you want to oversee the work yourself, you’ll need an owner-builder construction loan. You may have a harder time finding or qualifying for these loans, but if you do, you may be able to save money in overhead costs.

Renovation loan

If your construction project is improving an existing home rather than building a new one, you might choose a renovation loan. These loans allow you to buy a home and fix it up, or finance repairs or additions on a home you already own. You can also use a personal loan to fund home renovations or improvements. 

What costs can I pay for with a construction loan?

Typically, a home construction loan can only be used to pay for the actual costs of building the home — labor and materials, as well as permits, landscaping, and other necessary items. This generally doesn’t include furniture or other removable items. Some appliances may be covered by the construction loan, but you’ll want to make sure before you close.

What are the interest rates on construction loans?

As with any loan, interest rates on construction loans vary from day to day, from lender to lender, and based on your personal financial situation. But construction loan rates are generally higher than those on traditional mortgages, since you’ll typically make interest-only payments on the loan during construction — for up to 18 months — before making full principal and interest payments once the loan converts to a permanent mortgage.

With construction-to-permanent loans, you can typically lock in your interest rate for the permanent mortgage ahead of time. This allows you to shop around and compare interest rate offers from multiple lenders before settling on one.

How can I get a construction loan?

You may be able to get a construction loan from a traditional lender like a bank or credit union, or from a specialty lender. Lenders may offer their own construction loan programs or work through a government program — like an FHA construction loan, VA construction loan, or USDA construction loan. But you need to meet certain criteria to qualify for a construction loan, and the requirements can be more rigorous than for a standard mortgage.

Construction loan requirements

Most mortgages require a certain credit score to qualify, and construction loan requirements are often higher. Many lenders look for a minimum credit score of 680, and sometimes as high as 720, to qualify. You’ll also need to document your income and assets to demonstrate that you’re able to repay the loan.  

Construction loan down payments

Down payment requirements on construction loans are also often higher than for other types of mortgages. You may need to put down as much as 20% to 30% to qualify for a construction loan, though lower down payment options may be available depending on your credit. You can often find construction loans with down payments as low as 5%. Some programs, like VA construction loans and USDA construction loans, may not require any down payment. 

How to find a construction loan lender

Many banks, credit unions, and specialty lenders advertise their construction loans online. You should be able to find several lenders that offer construction loans in your area fairly easily. It’s vital to shop around for a construction lender before settling on a loan. Prequalify with several different lenders and get a rate quote to compare the interest rate, down payment requirements, and other loan features before choosing.

Alternatives to construction loans

While construction loans can be a great way to finance your dream home build, they’re not your only option. You may want to consider these other ways to get started on your construction project:

• Land loan — If you want to buy your lot before starting construction, many lenders offer land loans to finance the purchase. You’ll likely need to get a construction loan or other type of loan down the line to actually build.
• Home equity loan — If you own a home currently, you may be able to tap the home equity to build a new home. A home equity loan is disbursed as a lump sum, and a home equity line of credit allows you to draw from a maximum amount over time.
• Hard money loan — Hard money loans typically offer quick approval, but come with significantly higher interest rates and short loan terms.
• Personal loan — Personal loans are usually unsecured and come with higher interest rates, but can be used for virtually any purpose.