What Is a Construction Loan and How Does it Work?

Building a house is a chance to create your ideal 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 are temporary loans used to cover the cost of building or rehabilitating a house. The lender pays in installments as the work advances.

Once building is complete, home construction loans are either converted to permanent mortgages or paid in full. If the loan doesn’t automatically become a conventional mortgage, you may have to apply for a new 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 home that’s being built by a developer. In this case, the builder finances the construction. You choose from a set number of offered house plans and features, and when the construction is finished, you purchase the house from the builder with cash or a traditional mortgage.

How is a construction loan different from a traditional mortgage?

Unlike traditional mortgages, a construction loan is a short-term financing solution. The term is usually one year, and you’ll only pay interest during construction. This differs from a traditional mortgage, where you make payments towards principal and interest right away.

Depending on the type of construction loan you get, you may need to put 20% down at closing, while conventional mortgage borrowers are only required to put 3% down.

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.

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

A construction-only loan pays for the construction of the home and must be paid off when 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

Renovation loans are different from other kinds of construction loans because instead of building a whole new house, you use the financing to renovate a fixer-upper. With renovation construction loans, the cost of major renovations is wrapped into the mortgage. The loan is based on the home’s value after the renovation is completed.

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.

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.

What can you pay for with a construction loan?

Every project is different, but in general, a construction loan pays for:

• Land

• Plans, permits and fees

• Labor and materials

• Contingency reserves (in case the project costs more than estimated)