Solved! How Do Construction Loans Work?

If you’re considering building a new home, you may need a loan to finance the build, which is where construction loans come in. But how do construction loans work?

By Michelle Honeyager | Published Jun 29, 2022 5:41 PM

How Do Construction Loans Work

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Q: I’ve been looking to buy a home for a while but nothing on the market quite fits the criteria I’m looking for. Instead, I’m considering building a home from scratch, but I need a way to fund it. How do construction loans work, and how do I know which ones are right for me? 

A: If you’re wondering, “How do construction loans work?” you’re not alone. A construction loan is a type of loan that helps cover the costs of building a new home. There are several different types of construction loans, which are suited for borrowers’ varying needs. The main types include construction-only loans, construction-to-permanent loans, and owner-builder loans, though there are also several options if you want to complete a major renovation project on an existing home.

The type of construction loan you choose depends most directly on the project itself, but there are also other considerations. Construction loans are seen as much riskier by lenders than traditional mortgages are for several reasons, which can make them more difficult to qualify for. That also means that you may find higher construction loan rates compared to traditional mortgage rates. Learn more about what each loan type entails, how construction loans work, and the pros and cons of each so you can choose the best construction loan for you.

A construction loan is a short-term loan used to finance the construction of a residential property.

A construction loan is a type of loan that helps the borrower fund a residential construction; most commonly a new home. This short-term loan type can cover the purchase cost of the land, the cost of contractor labor, and the building materials and permits required to complete the project. Once the home is built, the borrower can either apply for a traditional mortgage to pay off the construction loan, or can choose to automatically convert the construction loan into a traditional mortgage. Unlike a traditional loan that provides the borrower with the funds directly, a construction loan provides payments to the contractor who is building the home in various stages throughout the home-building process.

Before approving a loan, the lender will likely require the borrower to hire a reputable builder who can get the job done within the time frame of the loan, complete the work well, and properly manage the loan payments to complete the project. Borrowers can find reputable contractors by consulting the National Association of Home Builders and by thoroughly checking the credentials of builders before choosing to hire one.

Construction loans are seen as higher risk than traditional mortgages and therefore tend to have higher interest rates.

Construction loans are generally viewed as much riskier to lenders than other, more traditional types of home loans. There are two main reasons for this.

First, a construction loan is not a secured loan in the same way that a mortgage is. With a mortgage, the borrower puts up the home as collateral, which means the lender will be able to sell the home to recoup its losses if the borrower defaults on the loan. This is not typically the case with a construction loan, unless the borrower already owns the land on which the home will be built; in that case, the borrower can put the land up as collateral and may be able to get a lower interest rate. However, borrowers who are taking out a construction loan for the purchase of the land in addition to the construction of the home will generally have higher rates and may find it harder to qualify for a loan.

Second, construction loans have much shorter terms than traditional mortgages. While borrowers may take out a 15- or 30-year mortgage, construction loans have shorter terms of around 12 to 18 months. The reason for the shorter loan term is that a construction loan is only meant to cover the time period when the house is being built, which is often a year or two or sometimes even less. If the project is delayed and ends up taking longer than the contractor initially estimated, this can result in the borrower being unable to pay off the loan at the end of the term. Even natural disasters such as floods can derail a construction project and prolong the project beyond the construction loan’s term. Since the lender is making a short-term loan for a large amount of money, these loans are considered risky and tend to have much more stringent requirements for qualification than would be the case for a traditional mortgage.

Because construction loans are riskier and therefore typically have higher rates, borrowers should consider carefully assessing their finances before applying for a loan to determine whether the higher interest rates are something they can realistically afford.

How Do Construction Loans Work

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There are several different types of home construction loans.

As previously mentioned, there are a few different types of home construction loans for a borrower to choose from. The first type is a construction-only loan. This type of loan funds the cost to build a new home for the length of the construction project. Once construction of the home is complete at the end of the loan term, the borrower must pay off the balance, typically by applying for a traditional mortgage to finance the home. This is called an end loan. Financing a home build this way can mean paying more in fees, such as closing costs, since the borrower is essentially applying for two separate loans.

Another option is a construction-to-permanent loan. This type of loan finances the construction costs of the home and then converts into a traditional mortgage at the end of the construction loan term. The benefit of this type of construction loan is that the borrower will only need to pay one set of closing costs rather than the two that would be required with a construction-only loan and then a traditional mortgage, which could save the borrower money. With both construction-only and construction-to-permanent loans, the borrower’s loan payments are typically interest-only, with the principal balance being due at the end of the loan.

A borrower who is a builder by trade may be able to qualify for an owner-builder loan. In this scenario, the borrower acts as their own general contractor and completes the construction of the home themself. However, to qualify for this type of loan, the borrower will generally need to prove that they are experienced, educated, and licensed, and therefore able to get the job completed in a timely manner, on budget, and up to local building code requirements. As such, this type of loan is typically not a realistic option for many borrowers unless they have professional working experience in construction.

Finally, the borrower may choose to apply for a renovation loan if they are making major updates or changes to an existing home rather than building a new one. One such option is the Federal Housing Authority’s 203(k) rehab loan. This type of loan allows the borrower to finance both the house itself and any required repairs. This is a good option for an older home that needs a lot of work, which would not typically qualify for a traditional mortgage. Using this loan, the borrower would purchase and completely remodel the home while making one monthly payment. The idea behind this type of loan is to help prospective homeowners buy “fixer-uppers” and get them up to date and livable.

Lenders base construction loan interest rates on the borrower’s creditworthiness and finances, as well as the loan size and term.

For a borrower who wishes to take out a house construction loan, a good place to start is to assess their finances, which includes checking their credit score, looking at their debt-to-income ratio, and using a construction loan calculator to determine how a construction loan would fit into their overall budget. When applying for a construction loan, it’s important for borrowers to have a handle on their financial viability since the loans have higher interest rates and are harder to qualify for than other loan types.

One the borrower has applied for the loan, lenders will strongly assess the borrower’s financial health when reviewing the application and determining whether to grant the loan to the prospective borrower. Lenders will typically look at the borrower’s credit score and ask for paperwork including recent check stubs, bank account information, and tax returns to assess the borrower’s finances. This will help the lender determine whether the borrower can reasonably pay back the loan by the end of the term. Lenders will also take into account the amount of money borrowed for the building project and how long it will take to pay back when deciding on whether to approve the loan.

For borrowers with fair credit scores who may have trouble qualifying for a construction loan, there are FHA-backed construction loan options. One option is an FHA one-time close construction loan, which allows the borrower to roll together the purchase of land, the construction of the new home, and the eventual mortgage into one single loan to avoid paying closing costs twice. The FHA requires borrowers to put down at least 3.5 percent on these loans. A borrower with the minimum down payment will need a credit score of at least 580 to qualify; borrowers who put down 10 percent or more can qualify with a minimum credit score of 500.

How Do Construction Loans Work

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The borrower will typically be required to provide the lender with a timeline, plan, and budget for the construction project.

The lender will typically ask for very detailed information from the borrower in order to approve the loan. This includes information from the contractor such as the project timeline, a detailed plan of the new construction, and a realistic budget. This allows the lender to fully vet the contractor and the construction plans to make sure everything is in order and to determine how much to lend to the borrower if the loan is approved.

The project timeline is also important because it gives the lender an idea of what the loan term should be. It’s important that the loan term matches the amount of time the construction project will take, because if the project runs over the borrower may be unable to repay the loan by the time the term ends. The budget is also important because if the project goes over budget, the loan may not be enough to cover the construction costs.

If the borrower and their contractor cannot provide this information to the lender, it may result in the loan being denied.

Lenders will usually review contractors to ensure they are licensed and experienced before approving a construction loan.

In addition to reviewing the construction plans and budget, the lender will want to make sure the contractor is licensed, insured, and experienced and holds the required licenses needed to operate locally. They may also see if the contractor is up to date on certification; for a borrower who uses a wheelchair, for example, the lender might check that the contractor is ADA (Americans with Disabilities Act) compliant if the contractor will be building an ADA-compliant home (sometimes called universal home design).

The lender will also look at the contractor’s experience building homes. Lenders want contractors that ideally have years of experience and are well known and reputable in their field. In order to make sure the contractor will meet the lender’s requirements, borrowers can search for contractors through the National Association of Home Builders. Contractors who are members of this professional association often have to meet stringent criteria for excellence and have years of experience building homes specifically. Being part of a professional association also means a contractor will likely receive ongoing training and keep up with the latest developments in their field. Because contractors are so closely scrutinized by lenders, that’s one more reason for a borrower to conduct thorough research before choosing a contractor.

How Do Construction Loans Work

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The lender makes payments, called “draws,” to the contractor at different phases of the construction project.

After reviewing the borrower’s finances, the contractor’s qualifications, and the details of the construction project, the lender will approve the loan if they feel confident that the loan will be paid and the project completed within the loan term. After that, the lender will make payments, also called draws, to the contractor directly.

While traditional loans disburse money to the mortgage holder upon closing, construction loan payments go directly to the contractor without the homeowner touching them. These scheduled draws go to the contractor during set phases of the construction project to pay for labor and materials. This is one of the reasons so much planning has to go into the project before the loan is approved. The lender needs to know the project schedule so they know when to send the draws to the contractor. While construction loans can be hard to secure, they can also mean easier financial management for the borrower, since all the borrower needs to worry about is making the monthly loan payments while the lender takes care of paying the contractor.

Some examples of times when the lender might make a payment to the contractor include when the foundation is poured, when the walls and roof are framed, when the drywall is installed, when the plumbing and fixtures are added, when the trim is installed, and when the finishing touches are completed.

The borrower usually makes interest-only payments during the construction loan term and will need to pay off the loan once construction is complete.

Another difference between a traditional mortgage and a construction loan is that the borrower typically makes interest-only payments during the loan term, and then pays off the balance after the home has been fully constructed. This can make the payments quite manageable during the period when the home is being built. For borrowers who are adding a construction loan to their regular living expense, this can be a big benefit. For instance, a borrower might be paying a mortgage on their current home while their new one is being constructed, which can feel like having two mortgages at the same time. Alternatively, the borrower may be between residences while their home is being built, so they may have extra expenses like paying rent on temporary housing. The interest-only payments can make the budget during this time more manageable.

If the borrower doesn’t want to wait to pay off the loan after the project is complete, they may be able to talk to their lender about paying off some of the loan principal during the construction period, provided their budget can handle it.

Once the home is completed, the borrower may have the option to convert the construction loan to a traditional mortgage.

Borrowers who opt for a construction-to-permanent loan will automatically have their construction loan converted into a mortgage once the home has been built. This type of loan is also referred to as a single-close construction loan, since the borrower won’t need to deal with closing and the associated costs after the home is finished. A borrower can take out a construction-to-permanent loan to finance the purchasing of the land and the new home construction, and then automatically have a mortgage to take the place of the construction loan. After that, the borrower will pay off the loan as they would any mortgage, with monthly payments that consist of principal and interest for a term of 15 to 30 years.

If the borrower chooses a construction-only loan, they will need to determine how to pay off the loan balance once the home-building project is complete at the end of the loan term. Many borrowers will opt to take out a mortgage to pay off the loan over a set period of time, typically 15 to 30 years. But unlike a construction-to-permanent loan, the borrower who chooses a construction-only loan must apply for a new mortgage, which means paying closing costs twice. However, some borrowers may prefer to do it this way, since it allows them to shop around and find the lowest possible mortgage rates for them at the time. In order to determine which type of construction loan to apply for, the borrower can look into average closing costs and mortgage interest rates to see which option offers the biggest potential savings to them.