Everything to know about construction loans

A construction loan can help pay to build a new home from scratch.

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Fierce competition and uneven real estate prices may have you thinking about building your dream home instead. Or, you may want to do a gut renovation, teardown or rebuild of an existing home, which can add significant value. 

But unless you can pay cash, you will likely need a construction loan. By answering a few simple questions here you can easily see how much you could qualify for.

Everything to know about construction loans

What is a construction loan?

A construction loan is generally used to pay for building a new home from scratch. It can be used to pay for materials, labor, land, permits and other items tied directly to building the home. 

In contrast to a traditional mortgage, a construction loan is typically a year to 18 months. That’s far shorter than a traditional 30-year mortgage. 

Funds from the loan are usually distributed at milestones, like completing the foundation. A construction loan borrower typically makes interest only payments in installments until construction is complete. For lenders, construction loans are considered riskier than regular mortgages.

Because of this, construction loans tend to carry higher interest rates than regular mortgages. Construction loan rates are adjustable, or variable, and move in the same direction as the federal funds rate, or the rate banks use to lend each other money. That means your payment and interest rate can climb as the Federal Reserve raises rates, as they have several times this year. 

Adjustable rates are different from a typical fixed rate 30-year rate mortgage, where your rate remains the same for the life of the loan.

There are several types of construction loans. Some are paid off with a lump sum, while others convert to a conventional mortgage loan once construction is complete. Construction loans can be harder to compare than regular mortgages. Choices depend on the lender, your credit history and the specific project, among other factors.

Compare your loan offers here now or use the table below to get started.

How to get a construction loan

To get a construction loan, you’ll need to take several steps to prepare. Experts typically recommend you:

  1. Find a licensed and reputable builder. One place to look is the National Home Builders Association directory, where you can narrow your search to your area. You can also ask a trusted real estate agent or financial adviser.
  2. Gather the necessary documents. Mortgage giant Fannie Mae’s model borrower form is one guide. Banks and financial advisors can also give tips.
  3. Check your financial health. Make sure you know your credit report details and try to have a 20% down payment plus a contingency fund ready.
  4. Prepare a detailed construction plan and timetable. 

Some federal programs, including the Veterans Administration and the U.S. Department of Agriculture, guarantee loans through certain lenders for qualified borrowers. While there are more application hurdles, benefits can include a lower required downpayment for qualified borrowers.

How do construction loans work?

In a construction loan, funds are usually distributed in stages as the project hits certain thresholds, like completing the foundation. Borrowers typically make interest-only payments while lenders pay installments to the builder at each milestone until construction is complete.

There are several types of construction loans. They typically require at least 20% down and well-drawn-out plans before a lender approve. 

Some construction loans may require a contingency fund for unexpected costs. The more stringent terms mean it can be tough to qualify, so do your homework.

What does a construction loan cover?

A construction loan typically includes costs for:

  • Land
  • Building materials
  • Labor
  • Permits
  • Major fixtures and appliances like heating and cooling systems
  • Appraisal once construction is complete

Types of construction loans

There are several kinds of construction loans. Here are a few popular options:

  • Construction-only loan: This loan must be paid off either in full or via refinancing into a regular mortgage loan. If you need to pay off the loan with a regular mortgage, you’ll go through two closings.
  • Construction-to-permanent loan (single closing): These kinds of loans can convert from an adjustable (or variable) interest rate into a fixed-rate mortgage once all milestones are met and construction is complete, including an appraisal of the home’s value.
  • Owner-builder loans: If you’re acting as your own contractor, you can apply for this type of loan and act as your own project manager.

Requirements to get a construction loan

Construction loans, with few exceptions, require at least 20% down payment, a higher credit score than you need for a typical fixed-rate mortgage, and often detailed plans about the project, down to a specific builder and permits required. 

You’ll also need detailed plans including cost of construction, how long construction will last, an estimated appraised value estimate for the complete home, and an estimated interest rate. Plan for closing costs of between 2% and 5% of the loan.

What are the risks of a construction loan? 

Lenders view construction loans as riskier than a regular mortgage for many reasons. Some of them include:

  • Material prices may rise
  • Loan rates climb higher than you plan as the Fed raises interest rates
  • You underestimate both the time and money needed
  • Trouble with the builder
  • You lose your job
  • Trouble with the land or permit delays
  • Contractor or builder estimate is too low 

Is a construction loan a good idea? 

A construction loan can be riskier than a regular mortgage – it’s a much shorter-term loan with a higher down payment.  

If you run the numbers, feel comfortable that it won’t stretch your finances too much and have a healthy contingency fund, then it can be very satisfying to build your own home. But know the risks going in. 

If you’re confident, shop around for various requirements and rates. Start exploring your loan options here now!

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