How Do Construction Loans Work?

A construction loan provides short-term financing so you can build a new home or renovate an existing home.

Here are some details:

• Loan terms are usually 12 to 18 months.

• You make interest-only payments during your loan term.

• After that, the loan either automatically converts into a mortgage loan or you refinance it with a mortgage loan.

Key Takeaways

• Construction loans fund short-term builds with 12 to 18 month terms and interest-only payments while your home goes up. Funds are released in draws as the builder hits milestones — not in one lump sum like a mortgage.

• You'll repay it one of two ways. A construction-only loan requires you to take out a separate mortgage, while a construction-to-permanent loan automatically converts to a mortgage so you close just once.

• Check if you qualify before applying. Most lenders want a credit score of 620 or higher, a 20% to 25% down payment, a vetted builder and a detailed build timeline — so line these up before you start shopping for a loan.

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Payments on Construction Loans vs. Mortgages

Unlike a mortgage loan, which pays out all at once, a construction loan is paid out in a series of draws against the principal amount as construction reaches certain milestones. You make interest-only payments until the work has been completed.

Repaying Your Construction Loan

How you repay the loan depends on the type you have.

• Construction-only loan: You'll apply for a separate mortgage loan and use the proceeds to repay the construction loan.

• Construction-to-permanent loan: The construction loan automatically converts into a mortgage. This type is sometimes called a single-closing construction loan.

Because you don't have to apply for a separate mortgage, you won't have to worry about closing a mortgage loan or paying a second set of closing costs.

Example: How a Construction Loan Works in Practice

Say you're working with a building contractor to purchase a lot on which you'll build a custom home.

• Lot cost: $100,000

• Home cost: $400,000

  • This includes permits, labor and materials.

• You need: $500,000

• 20% deposit = $100,000

• You'll need to finance $400,000.

• The loan proceeds go into an escrow account the builder will draw from to build the house.

• Your contract with the builder will include a schedule for these draws.

• It typically requires the homeowner to sign off on each after the lender's inspector has confirmed that the work has been completed.

The draw schedule might look similar to the one below, from the Mutual Savings and Loan Association:

• Draw 1: Due after land survey and preparation are complete and the builder has poured the foundation..

• Draw 2: Due after the framing is complete and windows and exterior doors have been installed.

• Draw 3: Due after the exterior has been primed for painting and plumbing, electric and HVAC have been roughed in and the roof is complete..

• Draw 4: Due after the exterior is complete and kitchen and bath cabinetry has been installed.

• Draw 5: Due after plumbing, electrical and HVAC work is complete, appliances have been installed and the lot has been graded and cleared of debris.

• Draw 6: Due after a final inspection and issuance of the occupancy permit to the homeowner.

During construction, the homeowner makes interest-only payments on the amount drawn. If the loan is a construction-to-permanent loan, it automatically converts to a mortgage after the last draw. Otherwise, the homeowner takes out a mortgage loan and uses the proceeds to pay off the construction loan.

Pros and Cons of Construction Loans

Construction loans make it possible to build a new home you can't afford to pay for out of pocket, but it's important to understand the drawbacks before you decide to use one.

Pros

• You can purchase a custom-built home on a lot you choose.

• You typically make interest-only payments on the outstanding balance.

• In most cases, the loan automatically converts to a mortgage, so you only have to close once.

Cons

• Compared to mortgage loans, construction loan rates are usually higher, and the loans are harder to qualify for.

• You'll have several documentation requirements and will have to do a lot of follow-up to apply for and close a construction loan.

• Construction projects are subject to unexpected delays and cost overruns.

Construction Loan vs. Mortgage: What's the Difference?

Construction loans and mortgage loans both help buyers finance home purchases, but that's where the similarities end.

Here's a comparison of the two loan types.

What You'll Need To Get a Construction Loan

Applying for a construction loan is different from applying for other loans you might've taken out, including mortgage loans.

Here's what you'll need.

• Construction loan preapproval: Research lenders to compare loan offerings and rates, and request a preapproval from the one with the best loan. A preapproval indicates that you have a good chance of being approved, and it tells you how much you're likely to qualify for — an important factor in planning your construction budget.

• Reputable builder. The lender will need to approve your builder, so look for one with experience and positive reviews. Also, search builders on your state's licensing board website to make sure they have a valid contractor's license and no disciplinary actions. The National Association of Home Builders is another excellent resource for vetting builders.

• Detailed building plan and construction timeline: You'll submit these documents and your construction contract with your construction loan application.

• Good credit: Lenders typically require a credit score of 620 or better for a construction loan.

• Proof of income: W-2 forms, pay stubs, 1099s, bank, investment and benefit statements and tax returns are some of the documents the lender might ask for to verify your income.

• Down payment: Most lenders require 20% to 25% down.

Is a Construction Loan Right for You?

A construction loan is just one way to finance a home purchase, so it makes sense to think through the decision to make sure it's the right one for you.

A construction loan is a good option if:

• You want to build a new home or renovate an existing one

• You have a reputable building contractor and a detailed construction plan and timeline

• You've been preapproved for a loan and have the cash for a down payment

A construction loan isn't ideal if:

• You want to move in quickly — it takes an average of seven to 14 months to build a home, according to Angi.

• You're uncomfortable with planning your build and handling the lender's documentation requirements.

FAQs

Can I get a construction loan with bad credit?

Yes, some lenders offer bank statement loans that they approve based on income instead of credit. They're considered non-qualified loans, and they're best used as business loans rather than residential ones.

How much down payment do I need?

Lenders usually require 5% to 20% down for a construction loan. If a home is $400,000, then 20% of that is $80,000.

What happens if the project goes over budget?

You'll need to pay the additional amount out of pocket or take out an additional loan if your construction project goes over budget.

Do I need to own the land first?

No. You can use your construction loan to finance your land purchase.

Can I act as my own contractor?

Yes, you may be able to act as your own contractor if you can prove to the lender that you have sufficient contracting experience.

Key Terms

• Construction loan: A short-term loan that helps pay for building a home or renovating one. Funds are released in stages as the work moves forward.

• Interest-only payments: Payments that cover only the interest charged on the amount borrowed. During this period, your loan balance usually does not go down.

• Construction-to-permanent loan: A loan that starts as construction financing and then converts into a mortgage after the home is finished. It can help you avoid a second closing.

• Mortgage: A home loan secured by real estate. If you don’t repay it as agreed, the lender can take the property through foreclosure.

• Draw schedule: A plan for releasing construction loan funds in steps as the project hits approved building milestones. Lenders usually verify progress before each draw.

Sources:

• Consumer Financial Protection Bureau: Mortgages key terms.

• Consumer Financial Protection Bureau: What is an interest-only loan?.

• Consumer Financial Protection Bureau: What is a mortgage?

• Consumer Financial Protection Bureau: TILA-RESPA Integrated Disclosures for construction loans.

• Federal Deposit Insurance Corporation: Construction and land development lending.

• National Association of Home Builders. National Association of Home Builders.

• Angi. How Long Does It Take to Build a House From Start to Finish?

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