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How does a construction loan work?
If you want to buy a house but the existing options on the market aren’t the right fit, you may want to take out a construction loan so you can build the type of home you want.
A construction loan is a great way to build a new home according to your preferences. But there are several unique procedures and costs you need to be aware of before seeking this option to pave your way to homeownership. Here's everything to know about a construction loan so you can decide whether to build or buy a house.
Learn more: How to buy a house
What is a construction loan?
A construction loan is a short-term loan that helps you buy a new construction home. It is often converted into a traditional mortgage once construction is complete.
Construction loans typically have terms of a year or less. These loans are meant to cover certain home-building costs, such as purchasing the land, buying and building materials, and paying for contractors and required permits.
How do construction loans work?
Because these loans are based on a short construction timetable, you and the hired contractor(s) need to make sure the project can be completed within the term set on the loan and that the mortgage lender approves the timeline.
Construction loans only finance the building phase of your home. During this time, you usually pay just the interest on money drawn from the loan. These loans typically have variable rates, and those rates are a little higher than what you’d get with a traditional mortgage because there is no collateral — a built home, in this case — so the loan is unsecured. Depending on what type of construction loan you have, once the building process is complete, the loan will probably be transferred into a mortgage. Then, you will start paying both the principal and interest, and you can opt for either a fixed-rate or adjustable-rate mortgage.
Learn more: What are land loans?
Construction loan vs. mortgage: What are the differences?
The biggest differences between construction loans and mortgages are what they’re used for and their term lengths.
A construction loan is only used to fund buying the land and building the home, whereas a traditional mortgage is for financing an existing or newly constructed home.
Also, construction loan terms are usually for a year or less, while a traditional mortgage term is much longer, typically between 15 and 30 years.
There are a few other crucial differences, too. For example, lenders provide funds for traditional mortgages as a lump sum upfront, while money for construction loans is paid out in phases. Also, interest rates tend to be higher for construction loans.
Read more: How to get a mortgage
Types of construction loans
There are several types of construction loans, each with its own way of converting into a mortgage once the building process is complete.
Construction-to-permanent loan
With a construction-to-permanent loan, the initial construction loan is converted into a traditional mortgage after the home is built. This is a helpful option if you want to pay just one round of closing costs.
The mortgage is typically for 30 years and has a fixed rate, but there are many lenders who offer shorter terms and adjustable-rate mortgages, as well. When the loan converts to a mortgage, you will start paying both the principal and interest.
Construction-only loan
You might pick a construction-only loan because you have enough cash to pay off the loan in full once construction is complete. Or you may want to use a certain lender for your regular mortgage that doesn’t offer construction-to-permanent loans, so you want to apply for the mortgage separately rather than transfer it with the same lender.
You can obtain a regular mortgage when the construction loan matures, but you would also have to pay a second round of closing costs for the mortgage after paying fees to get the construction-only loan.
Owner-builder construction loan
Owner-builder construction loans are rare, but in some cases, the borrower is also the home builder and can get a loan to finance the construction phase.
Most lenders would only allow this if the borrower is a licensed builder. Here are some advantages and disadvantages of owner-builder construction loans:
Pros
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You likely won’t need to hire a general contractor.
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You can build from your own house plans.
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You have a little more control over how you use the money from the loan since a general contractor is not involved.
Cons
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You must be a licensed or experienced builder to get loan approval by lenders.
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You are responsible for all of the work a general contractor would do, like hiring subcontractors and finding labor and materials.
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As the builder, you are also responsible for making sure the project is done on time and meets the lender's requirements.
End loan
An end loan is the long-term mortgage you get after construction is complete. It pays off the construction loan upon maturity, and usually at a lower, fixed interest rate. It’s often packaged with the construction loan by a single lender to simplify the process. However, this also limits your ability to shop around for another mortgage lender.
Renovation loans
If you already have a home but it needs an upgrade, you could instead seek out a renovation loan. There are a variety of options with these loans, such as a short-term personal loan or a government-backed loan with a 15-year to 30-year term. Many types of renovation loans come with their own borrowing limits and property requirements.
Also, if you’ve had the home long enough to build equity, you could use a home equity line of credit or home equity loan to finance a renovation.
Dig deeper: HELOC vs. home equity loan
How to get a construction loan
Getting a construction loan can often be a more costly and cumbersome process than obtaining a traditional mortgage. You’re essentially starting from scratch by purchasing the land, then building the home, then converting the loan into a mortgage.
At the outset, your lender will expect a timetable for completing the project, details of the plans, and your anticipated budget. Your general contractor may help you with this process. Once approved, the lender will gradually release funds at different phases of construction.
A home appraiser might periodically check in on the project to report to the lender before the lender releases more funds.
Many lenders will require you to have a credit score of at least 620 to 680, though some prefer higher. Construction loans generally require at least a 20% down payment.
How to get a construction loan with no money down
Most construction loan lenders will require some money down, typically 20%. But there are government-backed construction loans that require less. For example, loans through the Veterans Affairs (VA) office may require no money down, and Federal Housing Administration (FHA) construction loans can require as little as 3.5% down.
Some lenders allow a 5% down payment on conventional construction loans, and some will even waive that 5% if you meet other requirements. In Texas, for example, certain lenders will forgo the 5% down payment requirement if you have owned the land for at least 12 months and there is equity in the land you can use as collateral on the construction loan to essentially make up that 5%. Check with your lender to ask about ways they can help you lower the down payment.
Dig deeper: How much house can I afford?
What lenders offer construction loans?
Many large banks offer construction loans. Read Yahoo Finance reviews of the following lenders that have construction loans:
But there could be regional banks and lenders in your community that are better suited to issue a construction loan, depending on pricing and your credit profile.
You should also check with the institution you’re currently banking with because it might offer a better financing deal to keep your business.
A construction loan might be a good option for you if you’re willing to pay more to get exactly what you want in a house, you have the necessary cash flow, and you meet lender requirements.
But it’s important to thoroughly research all of the costs to build from the get-go, including local permits and construction labor on the land you’re selecting. The lender will expect this information up front, so be sure to have a plan you can afford and confidently present to the lender.
