What is a construction loan?
Updated April 18, 2022
Construction loans are short-term, varied-interest-rate mortgages granted to finance the construction of a new home or the renovation of an existing property. Construction loans do not apply to new homes financed by the developer or builder, only to properties financed by the owner. It is often easier to get approved for a conventional mortgage than to take out a loan to construct a new house, due to the increased risk on the part of the lender when investing in a property that doesn’t yet exist.
Construction loans—also known as construction-to-permanent loans, self-build loans or construction mortgages—are designed to finance custom-built properties. Usually, the borrower only pays interest on the loan until the property is completed. Once construction is finished, the loan principal becomes due.
Home construction loans are designed to finance custom-built properties. Paul Brennan/Pixabay
How does a construction loan work?
A construction loan is typically a short-term advance, usually granted for a maximum of one year, to cover the cost of building a new home. The money is released incrementally to the contractor—not the borrower—as work on the property progresses. The lender will arrange for periodic inspections to verify the progress of construction before releasing each payment. Usually, these loans are granted with variable rates that are higher than traditional mortgages. Once the property is completed, the owner can refinance the construction loan into a traditional mortgage or apply for a new loan, sometimes known as an end loan, to pay the construction loan off.
How do you apply for a construction loan?
To secure a construction loan, borrowers will need to provide a project tim++etable, a detailed budget and a list of construction details including floor plans, materials and building specs. Professional builders will often create a “blue book” that includes all the relevant details, which can help to convince lenders that the project is viable and low risk. The borrower is usually required to contribute a minimum 20% to 30% down payment on the loan, as construction loans are viewed as more risky than traditional mortgage loans.
Types of construction loan
- A construction-to-permanent loan converts to a traditional mortgage when building is complete. Also known as a single-close loan, it offers interest rates that are locked in at closing.
- A construction-only loan, also known as a two-close loan, must be paid off when building is complete. These loans are suited to borrowers who have large cash reserves or plan to shop for a permanent lender during the building phase.
- A renovation construction loan allows borrowers to wrap the cost of major renovations into a mortgage. The loan is based on the home’s estimated value after repairs and is useful when buying a dilapidated property that requires costly renovations.
- An owner-builder loan is a construction-to-permanent or construction-only loan where the borrower is also the home builder. These loans are typically only granted to licensed professional builders.
- An end loan is a mortgage that must be repaid after construction is completed. Unlike a construction-to-permanent loan, it requires a second loan closing.
Tips for borrowers:
Calculating the correct amount to borrow when applying for a construction loan can be complicated as it involves multiple factors and projects often come in over budget.
- Buying the land on which to build is usually one of the largest costs when constructing a new home. It is often easier to secure a construction loan if the buyer purchases the land separately prior to the application, ideally with an up-front payment or through a separate land loan.
- Lack of collateral can make lenders wary of issuing land and construction loans, so it is best to purchase a build-ready lot with a plan to begin construction immediately after purchase.
- A construction loan is more likely to be granted if the borrower is working with a licensed general contractor with an established track record of building new homes.
- Lenders may require the homeowner to take out a prepaid insurance policy that includes builder’s risk coverage.
- Borrowers planning to build their own homes will need to prove that they are experienced, licensed and insured.
- Self-built properties may be more suited to an owner-builder construction loan, sometimes called a DIY home build loan.
- Borrowers should allow a margin for extra costs when calculating the total loan amount required.
- While most construction loan lenders require a minimum down payment of 20%, it is sometimes possible to secure a 0% down loan from lenders that offer U.S. Department of Veterans Affairs loans or U.S. Department of Agriculture loans.
Construction loan closing costs usually vary from 2% to 5% of the total price of the project.