How Construction Loans Help Finance Your Dream House

Building a house is a chance to get everything you want in a home, and a construction loan lays the foundation for making it happen. Here's how the different types of construction loans work and how to choose a lender before breaking ground.

What is a construction loan?

Construction loans cover the cost of building or rehabilitating a house. The lender disburses the money in installments as the work advances. Once building is complete, home construction loans are either converted to permanent mortgages or paid in full. During the construction phase, the borrower pays only interest on the loan.

When is a construction loan used?

A construction loan can be used to finance a custom home — a house designed and built to your specifications — or to pay for a major renovation.

You don't need a construction loan to buy a production home in a new development. With a production home, the builder or developer finances the construction. You choose from a set number of offered house plans and features, and, when the construction is finished, purchase the house from the builder with cash or a traditional mortgage.

Construction loan types

Construction-to-permanent loans

A construction-to-permanent loan converts to a permanent mortgage when building is complete. Also known as a single- or one-time close construction loan, it's a convenient option because you apply and pay closing costs only once. The interest rate is locked in at closing. Lenders may also offer a "float-down option," which would let you get a lower rate at closing if mortgage rates improved during construction.

Construction-only loans

Also known as a "two-close" construction loan, a construction-only loan must be paid off when the building is complete. The loans require the borrower to qualify, get approved and go through closing twice — once for the construction loan and once for the permanent mortgage. Construction-only loans offer more flexibility because you can compare lenders to find the best deal on a construction loan and on a mortgage separately. The downside: You pay for two loan closings.

Construction projects are complex, and each one is unique. When shopping for financing, ask loan officers about the pros and cons of one-close and two-close construction loans and which would be the best fit for your project.

Renovation loans

With renovation construction loans, the cost of major renovations is wrapped into the mortgage instead of financed after closing. The loan is based on the home’s value after the renovation is completed. These loans make sense if you are buying a fixer-upper but don't have cash for the remodeling and repair work. Here are some low-down-payment renovation mortgage programs to consider:

• HomeStyle loans are guaranteed by Fannie Mae, a government-sponsored entity, and have a minimum down payment requirement as low as 3%.

• CHOICERenovation loans, guaranteed by Freddie Mac, also a government-sponsored entity, allow renovation costs up to 75% of the appraised value after the improvements are completed. The minimum down payment varies, but it can be as low as 3%.

• FHA 203(k) loans, insured by the Federal Housing Administration, require a down payment as low as 3.5%.

• USDA renovation loans, backed by the U.S. Department of Agriculture, are zero-down payment loans for low- to moderate-income borrowers in eligible rural areas. They are available through approved lenders.

The HomeStyle, CHOICERenovation and FHA 203(k) loans can also be used to refinance a current mortgage and include the costs of a remodeling project.

» MORE: Buy, build or fix: What's best for first-time home buyers?

Owner-builder loan

An owner-builder loan is for someone who plans to build their own home and act as the general contractor. Borrowers need to have building experience to qualify, and not all construction lenders offer owner-builder loans.