How Does a Construction Loan Work?

A construction loan is short-term financing that covers the cost of building a residential stick home from the ground up to finish. Shutterstock

If you can’t find the perfect home, building one is an option. But a lot goes into building a house. One of the most critical aspects of building is the financing. When building, you don’t just apply for a mortgage; it takes a construction loan.

But what is a construction loan, and what are the qualifications? Knowing the ins and outs of construction loans will help your build go much smoother. After all, there are already enough headaches when building.

Construction Loans and What They Cover

A construction loan is short-term financing that covers the cost of building a residential stick home from the ground up to finish. It covers a wide range of costs, all associated with building. They include:

• land
• labor costs
• material costs
• permits

They’re different from traditional mortgages and come with specific qualifying requirements.

Qualifying for a Construction Loan

When you apply for a traditional mortgage, you secure the loan with a completed house. If you default on the loan, the financial institution takes the house.

A construction loan isn’t secured by a completed house, so the application and approval process are more complex.

The lender will inspect architectural plans and examine your financial situation before approving the loan.

Construction Loans Interest Rates

Similar to other loans, construction loans vary based on your creditworthiness, size of loan and term. The lender will require an appraisal of the value of your future home. Once you have the appraisal value, the lender will determine how much it will lend.

Interest rates are usually variable. This means they are adjusted throughout the loan based on an index, like the prime rate. Construction loan interest rates are higher than traditional mortgages. They can run as high as 10 percent APY (annual percentage yield).

A 20 percent down payment is required.

How Do Construction Loans Work?

Construction loans work on a short timetable and depend on the project’s progress. For that reason, the lender will usually request an estimated construction timeline and a realistic budget

When construction begins, you begin paying down the interest on the loan. Depending on your lender, you will pay monthly or quarterly. While you pay the interest, work progresses. The principal is used to pay for the construction.

The lender will release funds based on various phases of the project directly to the contractor. Releasing the funds is called a “draw.” In other words, a construction loan works like a line of credit. Money is only released when needed.

Differences Between Construction Loans and Traditional Mortgages

If you’ve only had traditional mortgages in the past, do note some key differences between construction loans and traditional mortgages. It’s important that you understand them so you can make informed decisions.

One that was previously discussed is the funds distribution. Traditional mortgages pay one lump sum, whereas construction loans pay draws. These draws happen when significant milestones are completed, such as the foundation laid or framing completed.

Another difference is that with a traditional mortgage, you start paying principal and interest per month immediately after the loan closes. But with a construction loan, you pay interest, and the principal goes toward construction.

During the construction, the lender has an inspector or appraiser check the house during various phases. When the work is approved, the lender releases funds to the contractor. You can expect four to six inspections to monitor progress.

4 Types of Construction Loans

Just like there are different types of construction, there are different types of loans. Each is designed to suit various financial needs.

Construction-to-Permanent

After completion, the construction-to-permanent loan becomes a traditional mortgage. You can choose from 15 years to 30 years. You may also opt for an adjustable or fixed rate. Once it becomes a traditional mortgage, you start paying interest and principal.

The upside of converting to the lender’s traditional mortgage is that you only have to pay closing costs once.

Construction-Only Loans

With a construction-only loan, you borrow money to build the home. And although you must pay the loan back typically in one year or less, you don’t have to apply to the same bank for the mortgage to repay the loan.

You might find another bank or credit union with better terms. You can borrow money from the second financial institution and repay the construction loan lender with those funds.

The downside is that you now have to pay closing costs twice. You also must take the time to shop around for a mortgage instead of just staying with the first one.

Renovation Loan

Some people just want to upgrade their current home. If this is you, consider home renovation loan options.

If your budget is $20,000 or less, consider a personal loan. For renovations over that, a home equity loan or line of credit is appropriate.

Another viable option, although current interest rates may deter this, is a cash-out refinance. This is when you take out a new mortgage in a higher amount and use the excess to do renovations.

Owner-Builder Construction Loan

An owner-builder loan is similar to construction-only loans or construction-to-permanent loans. The difference is that you also act as the contractor.

Most lenders will not let the borrower act as their own contractor, but they will make an exception if the borrower is a licensed builder by trade.

Construction Loans Pretty Straightforward

Although construction loans are straightforward, there are several hoops to jump through before and during the construction phase. Financial institutions are hands-on when it comes to monitoring these loans. But if you don’t mind the work, it could be worth it.

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