Updated: October 9, 2024
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Finding the right house can be a challenging endeavor, and some buyers may decide to build their own home instead. However, financing this type of project is often complex — that’s where construction loans come in. These loans provide the funds needed to build your home, from start to finish.
Exploring what construction loans are, the different types available and how to get one will help you decide if this financing suits your needs.
A construction loan is short-term financing for covering the costs of building or renovating a home, typically issued for a year or less.
Construction loans come in different types, including construction-to-permanent loans, construction-only loans, renovation loans, owner-builder loans and end loans.
Construction loan rates are typically higher than traditional mortgages and are often variable, depending on the borrower’s credit and the loan terms.
A construction loan is short-term financing used to cover the costs associated with building or rehabilitating a house. Unlike a mortgage, which provides long-term funding for a completed home, a construction loan is considered specialty financing because it is only used during the building process.
Construction loans typically cover the following costs:
It’s worth noting, however, that construction loans don’t include design costs, such as architectural fees or interior planning. These must be managed separately from the loan.
Construction loans are short-term loans, usually lasting for one year or less, to cover the costs of building or renovating a house. The application process involves submitting detailed plans for the project, including cost estimates, timelines and the credentials of your contractor or builder. Lenders carefully review these details because construction loans carry more risk than traditional mortgages.
Once approved, construction loans disburse funds in stages, referred to as "draws." These occur at specific milestones in the construction process, such as when the foundation, framing or roofing are completed. Your lender typically requires inspections at each stage to ensure the project is progressing as planned. Interest is usually charged only on the amount disbursed, and during the construction phase, payments are often interest-only.
When construction is complete, you have options for handling the loan. You can refinance the construction loan into a permanent mortgage or take out a new loan to pay off the balance. Some construction loans automatically convert to a traditional mortgage, simplifying the transition to long-term financing.
Construction loans come in different types, offering flexibility depending on whether you're building a new home, renovating an existing one or handling the construction yourself. Understanding these types can help you choose the best option for your project.
A construction-to-permanent loan covers both the building phase and your long-term mortgage. Initially, it functions as a construction loan, providing funds during the construction process. Once construction is complete, the loan automatically converts into a permanent mortgage, eliminating the need for refinancing.
This option is convenient for borrowers who want to simplify their financing and avoid closing multiple loans. Payments during construction are usually interest-only, based on the disbursed amount.
A construction-only loan provides funding solely for the building phase. It does not convert into a mortgage once construction is complete, meaning you must refinance or take out a separate loan to pay off the balance. These loans may be appealing for borrowers who want flexibility in choosing a permanent mortgage after construction. However, they require you to go through two separate loan closings, which can involve additional costs and paperwork.
A renovation loan finances the rehabilitation or remodeling of an existing home. These loans are ideal for homeowners who need to upgrade their current property rather than build a new one. The loan amount is typically based on the future appraised value of the home after renovations are complete.
Renovation loans can cover repairs, expansions or aesthetic updates and are often integrated into a permanent mortgage, allowing borrowers to spread payments over time. Here are some low-down-payment renovation mortgage programs worth considering:
HomeStyle Loans: Backed by Fannie Mae, HomeStyle loans allow borrowers to finance home renovations with as little as 3% down. These loans are available for primary residences, second homes and investment properties.
CHOICERenovation Loans: Freddie Mac's CHOICERenovation loans offer flexible renovation financing with as little as 3% down. They allow borrowers to use funds for disaster-proofing renovations and cover both cosmetic and structural improvements.
FHA 203(k) Loans: The FHA 203(k) loan program lets borrowers finance renovations with a down payment as low as 3.5%. This program is specifically designed for purchasing and renovating primary residences.
USDA Renovation Loans: USDA renovation loans provide 100% financing for home improvements in eligible rural areas. These loans are aimed at low- to moderate-income borrowers and can cover both purchase and renovation costs.
An owner-builder loan is designed for individuals who plan to act as their own general contractor for the construction project. These loans require borrowers to have significant experience in construction or home building because lenders take on more risk when the borrower manages the construction themselves.
This type of loan provides flexibility for those who want to oversee every aspect of their home’s construction, but the approval process can be more rigorous than that of other construction loans.
An end loan is a traditional mortgage that takes effect after the construction phase is complete. This loan differs from construction loans because it provides long-term financing only after the construction is finalized.
Typically, borrowers use a separate construction loan to finance the building process and then transition to an end loan, which covers the permanent financing for the home. This option requires two separate loan closings and can lead to additional closing costs.
Construction loan rates vary based on factors like the borrower’s creditworthiness, loan size and loan term. Typically, these loans come with variable interest rates, which means the rate can fluctuate over the course of the loan. This can lead to changing monthly payments during the construction phase.
Because construction loans are unsecured, meaning there’s no existing property as collateral during the build, interest rates tend to be higher than the current rates for traditional mortgages. Lenders charge more to offset the added risk of financing an incomplete property.
Eligibility for construction loans requires meeting specific criteria that demonstrate your ability to complete the project and repay the loan. Lenders look at several factors to determine your qualification for this type of financing, including:
A good credit score is essential for securing a construction loan. Lenders typically prefer a score of 680 or higher, though some may consider lower scores with stricter terms. A strong credit score shows you’re reliable in managing debt, which reduces the lender’s risk.
Lenders assess your debt-to-income (DTI) ratio to ensure you have enough income to cover the loan payments. A DTI below 45% is usually required, though lower ratios are preferred. This ratio helps lenders evaluate whether you can manage your current debts along with the construction loan.
A larger down payment is usually required for construction loans, often around 20% of the total project cost. This is because lenders take on more risk when financing a home that hasn’t been built yet. A higher down payment reduces their exposure to potential losses.
Lenders require you to choose a licensed and experienced builder for the construction project. The builder must provide credentials and a history of completed projects. This ensures that the construction will be completed by a professional capable of managing the project efficiently.
A detailed construction plan is necessary for approval. This plan should include cost estimates, timelines and project details. Lenders use the plan to determine the loan amount needed and assess whether the project is feasible and within budget.
The loan-to-value (LTV) ratio is a key factor that lenders consider when approving construction loans. It’s calculated by dividing the loan amount by the property's appraised value. For construction loans, lenders typically prefer an LTV ratio of 80% or lower, meaning you’ll need at least a 20% down payment.
A lower LTV ratio reduces the lender’s risk and can lead to better loan terms, such as a lower interest rate. — Alvin Yam, CFP
Securing a construction loan involves several steps that ensure you are prepared to finance and manage your home-building project. Following a clear process will help you meet lender requirements and make the loan approval smoother.
Select a licensed and reputable builder with experience in similar construction projects. Lenders typically require the builder to be certified and have a history of successfully completed projects. Make sure your builder provides credentials and references to strengthen your loan application.
Research and select a lender that offers construction loans with favorable terms. Make sure the lender also has experience in handling construction financing, as they will guide you through the specialized process. Compare interest rates, fees and loan conditions to find the best fit for your project.
Prepare the necessary documents, including your financial information, detailed construction plans, builder contracts and cost estimates. This paperwork helps the lender assess the project’s feasibility and your ability to repay the loan. Providing accurate and thorough documentation speeds up the approval process.
Submit your paperwork to get pre-approved for a construction loan. Pre-approval gives you a better idea of how much you can borrow and ensures you're financially ready to begin the project. It also shows builders and contractors that you are serious about moving forward.
Before closing on the loan, purchase homeowners insurance that includes coverage for the construction phase. Lenders often require this insurance to protect against potential risks during the building process. It also ensures that your property will be covered once construction is complete.
Getting a construction loan with no money down is challenging but possible through certain loan programs. One option is a USDA construction loan, which offers 100% financing for eligible borrowers in rural areas. You must meet income limits and property location requirements to qualify.
Another option is a VA construction loan, which provides no-down-payment financing for veterans and active-duty military members. To qualify, you need a Certificate of Eligibility and meet the lender's credit and income standards.
We answered some frequently asked questions about construction loans to help you decide if this option is right for your particular needs.
Qualifying for a construction loan can be more difficult than qualifying for a traditional mortgage because it carries more risk for the lender. You generally need a strong credit score (usually 680 or higher), a low debt-to-income ratio and a significant down payment (often 20% or higher). Additionally, lenders require detailed construction plans, a licensed builder and proof that you can manage the project within budget and on schedule.
Construction loans differ from traditional mortgages in that they finance the building process, while traditional mortgages finance the purchase of an existing home. Construction loans are disbursed in stages as the project progresses, and they often have higher interest rates because they are considered riskier. Additionally, construction loans are short-term and may require refinancing into a permanent mortgage after construction is complete.
Funds from a construction loan are disbursed in stages, known as "draws," which are tied to project milestones. For example, draws may be issued after the completion of the foundation, framing or roofing. Before each draw is released, the lender typically inspects the construction progress to ensure the funds are being used as planned.
Yes, interest rates on construction loans are usually higher than traditional mortgages because the loan is riskier. The house is not yet completed, so lenders have more exposure if the project stalls or fails. Additionally, construction loans often have variable interest rates that can fluctuate during the building process.
Yes, you can get an owner-builder loan if you plan to manage the construction yourself. However, lenders are cautious with these loans because they require significant construction experience. You must prove that you have the skills to manage and complete the project on time and within budget.
Yes, renovation loans are a type of construction loan designed specifically for updating or rehabilitating an existing home. These loans, such as FHA 203(k) or Fannie Mae HomeStyle loans, allow you to finance both the purchase and renovation of the property.
After construction is complete, you can refinance the construction loan into a permanent mortgage. This can either be done by taking out a new loan or automatically transitioning into a construction-to-permanent loan. In either case, the permanent mortgage will have a longer term, such as 15 or 30 years, and regular monthly payments.
If the construction project takes longer than expected, you may need to request an extension from your lender. However, some lenders may charge fees for extending the loan term. If the delay is significant, you may need to refinance the loan to avoid default.
About Zachary Romeo, CBCA
Zachary Romeo is a certified Commercial Banking and Credit Analyst (CBCA), and the Head of Loans and Banking at MoneyGeek. Previously, he led production teams for some of the largest online informational resources in higher education, with over 13 years of experience in editorial production.
Romeo has a bachelor's degree in biological engineering from Cornell University. He geeks out on minimizing personal debt and helping others do the same through people-first content.
The content on this page is accurate as of the posting/last updated date; however, some of the rates mentioned may have changed. We recommend visiting the lender's website for the most up-to-date information available.
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