Types of construction loans
There are a few types of home construction loans. Which type will work best for you depends on your needs. Bear in mind that just because a lender offers construction loans does not necessarily mean they offer all types — you'll need to zero in on lenders that have the kind of loan you want. Loan type | Best for | How it works |
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Construction-to-permanent loan | Most homebuyers looking for a construction loan | Pays for construction, then automatically converts to a standard mortgage when building's done. One loan means only paying closing costs once.
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Construction-only loan | Buyers who plan to shop for a mortgage later or who have funds to pay the balance on the completed home | Covers only the building phase. After construction, you have to pay off the loan or take out a traditional mortgage. Starting a new mortgage means another round of underwriting and closing costs.
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Renovation loan | Buyers or homeowners upgrading an existing home | |
Owner-builder loan | Experienced builders acting as their own contractor | |
Government-backed construction loans | Buyers looking for more flexible qualifications | Construction loans backed by the VA, FHA and USDA are available. Often allow for lower down payments and credit scores. Can be hard to find lenders offering these loans.
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If you're buying a newly-built home that's already finished, you don't need a construction loan. Since you're not paying for the building process, a regular mortgage will work. (A mortgage that starts once construction ends is sometimes referred to as an end loan, but it's just a regular mortgage.) The only difference from a normal home purchase is that you might have to pay a builder's deposit. That earnest money is separate from your down payment. Is a construction loan harder to get than a mortgage?
Yes. Think about it from the lender's perspective: It's a bit more risky than a regular home purchase since there's no finished house as collateral for the loan. One way to think about construction loans is that the lender is underwriting both you and your project.
Lender requirements for construction loans tend to vary more than with regular purchase mortgages. Here's a list of typical requirements for construction loans, and how they compare to a conventional purchase loan. Requirement | Construction loan | Conventional loan |
|---|
Credit score | 620-680, some lenders require 700+ | As low as 620 |
Down payment | 3-20% | As low as 3%, generally no higher than 5% |
Debt-to-income ratio | 45% or less | 45% or less |
Cash reserves | 0-12 months' of housing payments | 0-6 months' of housing payments |
Loan term | 6-18 months for the duration of construction | Up to 30 years |
Note that those are just the requirements for the borrower. A construction loan lender will also evaluate your builder's credentials and the project plans.
How construction loans work, step by step
Building a home with a construction loan is different from buying an existing house with a traditional mortgage. Instead of receiving the full loan amount at closing, you typically get funds in stages as construction progresses. There's also a lot you'll do before even approaching lenders. Here’s how the process usually works.
Preparation steps
1. Secure your building site
It may feel obvious, but yes, step one is figuring out where the home will be built. You may already own the land, be buying it as part of the construction loan or be starting from scratch. If you still need to purchase a lot, some lenders will roll the cost of a lot loan into a construction loan; others may offer lot loans separately.
2. Choose a licensed builder
This is a massive step we're summarizing super fast. To get a construction loan, you'll need to work with a reputable builder and have legit construction plans. As part of your loan application, the lender will check the builder's license, finances and more. You or the builder will also need to provide construction information like blueprints, a budget and a construction schedule.
3. Obtain homeowners insurance
Even though your home isn't built yet, you'll need homeowners insurance. Most lenders require a policy with builder's risk insurance, which covers the materials and structure during construction. Once you've got these pieces in place, you're ready to start looking at construction loan lenders.
Getting a construction loan
4. Compare construction loan lenders
Look for a lender that offers the type of loan you need, competitive interest rates and terms that fit your budget and timeline. (This list is a great place to get started!)
Applying for preapproval with different lenders can help you see how much you could qualify to borrow and what interest rate you might get. Again, in addition to the usual paperwork — like pay stubs and tax returns — even at this stage you may need to provide information like building plans and your builder's references. If you're working with a developer or a larger builder, they may offer you financing or a loan through a lender they work with. Using their lender could make the process easier, plus the developer might offer you incentives. But it's still a good idea to compare different construction loan lenders — how do you know you're getting a deal if you're only looking at one set of numbers?
5. Apply for the construction loan
The application process is more involved than a standard mortgage application because, as we've already noted, the lender is evaluating both you and the construction project. You’ll need to provide the usual mortgage documents, like pay stubs, tax returns and bank statements. The lender will also review your credit score, income, debts, down payment and cash reserves.
The less-usual documents include building plans, cost estimates and paperwork from your builder.
6. Get an appraisal
This is another "but the home doesn't exist yet" step. With a new build, the appraisal is based on the as-completed value. An appraiser will review your land and building plans, then find recent comparable sales for your finished home. Their appraisal will be an estimate of the future value of your completed property. Same as with any mortgage, the appraisal helps the lender decide how much it is willing to lend. If the appraisal comes in low, you could need to increase your down payment, revise your building plans or figure out additional financing.
Once you've made it through underwriting and the loan closes, construction can begin. During construction
7. Lender releases funds
Construction loans are usually paid out through draws, which are scheduled payments. These are usually tied to project milestones. For example, the builder might receive funds after completing the foundation or roughing in utilities.
This funding might never touch your bank account; depending on the lender and the loan type, the money may be disbursed directly to the builder or contractor.
Before each draw, the lender may require an inspection to confirm that the work has been completed. This helps the lender ensure the funds are being used as intended and the project is staying on track.
8. Borrower makes payments
During construction, borrowers can often make interest-only payments, covering just the interest on the loan balance. The loan balance is usually based only on the amount of money that has been drawn, not the total loan amount.
For example, if you have a $500,000 construction loan and so far $200,000 has been paid out, your interest payment would be based on the $200,000 balance. This can get tricky, because your monthly payment amount will rise as more of the loan is disbursed — though interest-only payments will always be lower than repaying principal and interest.
As a final step, your lender may ask for proof that the home has been completed, like a certificate of occupancy.
Build or buy? What to consider
Building your own home can sound like a simple solution, particularly if you've been having trouble finding existing homes that suit your needs. But it's important to recognize that the process is complex and there are risks involved. Understanding the potential downsides can help you decide whether building over buying is right for you.
Higher interest rates and loan costs
Construction loans often come with higher interest rates than standard mortgages to reflect the lender's added risk (after all, you're borrowing money for a home that doesn't exist yet). Construction loans can also come with inspection fees, draw fees and other administrative costs that can add to your bill. And if you have a two-close loan, you'll pay closing costs twice.
More complicated approval process
As we've detailed above, qualifying for a construction loan is typically harder than getting a traditional mortgage. Lenders evaluate not only your finances, but also the details of the construction project and the builder. It's a lot to pull together, and delays on your end (gathering the paperwork) or the lender's (approving it all) can slow down the process.
Uncertainty
There are a lot more what-ifs with a construction loan, since so much can happen during the construction process. Some you can plan for, for example by keeping cash reserves set aside and really vetting your contractors. Others, however, are out of your control.
Cost overruns: If construction costs end up higher than expected, you’re usually left footing the bill for the difference. Costs can change due to rising material prices, difficulty finding labor or design changes.
Delays: Weather, permitting issues, supply chain snags and contractor availability can all affect your project's schedule. That can increase your costs, since interest is accruing over a longer period and (depending on the lender) may trigger a penalty fee. It's also more time that you're paying for other housing so you have somewhere to stay during construction.
Builder conflicts: Your builder is the backbone of the entire operation, and if they aren't living up to expectations you can face major headaches. Because the lender approved the builder as part of approving the loan, trying to switch builders midway can be challenging.
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