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Construction loans: What they are and how they work

Construction loans: What they are and how they work

Here’s how to get financing if you want to build or remodel

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Updated: 09/08/2023

When you are ready to find your forever home, you aren’t limited to only the prebuilt homes on the market. With the help of a construction loan, you can finance a new build or remodel an existing home — either one you already own or one you want to fix up.

Construction loans are different from taking out a new mortgage loan. It is considered specialty financing and is offered in shorter terms than traditional mortgages. Here’s what you need to know to qualify for this type of loan and find a lender that works for your building or remodeling goals.

Key insights

Construction loans can have stricter borrowing requirements than traditional mortgages since collateral hasn’t been established yet.
Expect shorter terms for construction loans (up to two years) but with the option to refinance the loan to traditional mortgage terms.
Part of the approval process will involve the lender signing off on your builder and building plans.

Construction loans vs. traditional mortgages

The biggest difference between construction loans and a traditional mortgage is the time frame in which you can borrow money. A traditional mortgage is typically for 15- to 30-year terms, whereas a construction loan is generally six months to two years.

In a traditional mortgage, the entire loan amount is disbursed at closing. However, with construction loans, the money is released in stages as construction milestones are reached. Once the construction is complete, borrowers can refinance the construction loan into a traditional mortgage. This can be planned ahead of time, with some lenders offering construction-to-permanent (C-to-P) loans.

» MORE: Is buying a house a good investment?

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

“Construction loans can have stricter qualification criteria compared to traditional mortgages,” said Mike Romano of Stairs Financial, a company that helps first-time homebuyers find qualifying down payment assistance programs.

“Lenders generally require higher credit scores, larger down payments and evidence of financial stability to mitigate the risks associated with construction projects.”

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

A 620 credit score or better: Some lenders will require a minimum score of 680, whereas FHA-related construction loans might be more lenient with credit score requirements.
Low debt-to-income (DTI) ratio: Aim for a DTI that is no greater than 45%; the lower the better.
Proof of stable income: Since you are a greater risk to lenders, they want to see that you can afford this new build or reno project.
A licensed builder: “Lenders will confirm that your chosen builder has references and a past history of paying suppliers and completing projects,” said Romano. “Your builder should expect to have to provide professional licenses, proof of insurance and payment histories.”
Construction plan: The more detail the lender can provide about the blueprints and timeline of the build, the better.
Appraisal or projected home value: “Since the collateral for a construction loan is the property that has yet to be built, lenders may conduct appraisals during the construction process to evaluate the project's value,” Romano added.

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

» MORE: When is the best time to buy a house?

How to get a construction loan

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

Gather your financial information

Even though construction loans are for a shorter term than a traditional loan, they will have stricter requirements. Take time to gather all of your financial documents — this includes income, debts, assets and credit history . If your finances or credit score are not where you would like them, now is the time to improve them.

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. Look for a lender that is experienced with handling construction loans. Have your land contract and lot deed ready, if applicable.

Some builders will recommend you use their lender for faster approval, but that might not always be the best choice. Laura chose to build a house when moving to Florida. “One concern [was] not going with the builder's mortgage company. What if this mortgage company can't get me the mortgage in time?,” she told ConsumerAffairs when she chose to use a mortgage company she had used three times before instead of the builder’s company.

“[The mortgage company’s rates] definitely beat out the builder, for sure. The builder wanted to give me a higher — the closing costs were higher and everything,” she said.

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.

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.

Apply for the construction loan and complete an appraisal

Before the loan closes, you will need to obtain a property appraisal. The appraiser evaluates the building plans, the construction budget and local comparable sales to estimate the future value of the home once it's built.

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.

» MORE: How to finance home renovations

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.

» COMPARE: Best home warranty for new construction

FAQ

What do construction loans cover?

Construction loans cover the costs of land purchase, building materials, licensed contractor labor, inspections and permits. The funds can also be used for building plans and closing costs. A construction loan can include funding for permanent fixtures, such as appliances, and it covers finishing materials such as countertops or flooring.

What is the average construction loan interest rate?

Construction loan rates typically hover around 1% more than current mortgage loan rates. Individual rates vary by lender, loan type and borrower qualifications.

How long does it take to get approved for a construction loan?

The approval process for a construction loan can vary greatly depending on the lender and your specific financial situation. Typically, the process begins with an initial application where you'll provide details about your income, debts and credit history. After this, you'll need to provide detailed plans for your construction project, including cost estimates, timelines and building plans. Overall, the entire process can take anywhere from a few weeks to a few months.

What happens if the construction goes over budget?

In some cases, the lender may be willing to increase the loan amount, but this will likely depend on the reason for the cost overrun and your financial situation. It's also worth noting that going over budget could delay the construction schedule, which could lead to additional costs. If the lender does not extend funding, you will need to cover the additional costs or seek additional financing.

Bottom line

If you’re looking to build a new home or renovate an existing property, construction loans will give you access to the financing you need.

Construction loans offer unique benefits for buyers who need financing to work with a builder, including phased disbursements based on construction milestones. While these loan types also come with a more complex approval process and higher down payment requirement, the right lender will be able to walk you through the process.

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