What Is a Construction Loan?

FT Contributor  | 

Building a house can be expensive. Some people may have the budget to build, but many can’t pay for the total cost of a new home upfront. Most people need a loan to start on new construction. Unlike a mortgage, construction loans are a short-term loan used to pay for the costs of a new build. They can be offered for a set term to allow you enough time to build your new home.

Once construction is complete, a new loan — often called an “end loan” — is required to pay off your construction loan. In other words, your loan is refinanced and you enter into a new loan that’s typically a fixed-rate, 30-year mortgage. If you’re in need of a construction loan, be wary that there are often many strict qualifications that must be met. Banks fear that the new building won’t be worth as much as the loan. Learn more about what you’ll need in order to get a construction loan for your new home.

How Do Construction Loans Work?

Construction loans are typically short-term (generally a year or so) and used to pay for the building of a home. Once you qualify and are approved for a construction loan, the lender begins paying out money. Lenders don’t just give the builder the cash all at once. Instead, a schedule of draws, or designated intervals, is set up. These intervals denote when a builder will receive funds to continue working on your construction.

Several draws occur throughout the duration of your project. In the beginning, your builder might receive 20% of the loan and then the next 10% when another building milestone is reached, like pouring concrete to establish the foundation. The number of draws your loan requires is negotiated between you, your builder, and your bank. To ensure your project remains on track, banks often require inspections to occur at each stage of the building process prior to the next draw.

Like other loans, construction loans come with interest. Most often, construction loans are variable rate loans, with a rate set to “spread” to the prime rate. This means your interest rate equals the prime rate plus a certain amount. As the prime rate changes, so does your interest rate. Say the prime rate is 5% and the rate at which you obtain your construction loan is prime-plus-one. You would pay 6% in interest on your construction loan.

Sometimes, construction loans are set up as interest-only loans. Instead of paying down your principal balance, you only pay interest on the money you borrow, making construction loans more feasible for many. In other words, with interest-only loans, you’re also responsible for paying down the amount that has been paid out already. Say you borrow $200,000 and the first $10,000 has been paid to your builder. You would only be charged interest on the $10,000, not the total price of the loan. Just as you would with a conventional loan, you’re expected to make monthly payments.

Construction-to-Permanent Loan

This type of loan provides you with enough funding to pay for your build and your permanent mortgage. Typically, a down payment of 20% is required with a construction-to-permanent loan, but some lenders are flexible. Initially, you’re only charged interest on the amounts drawn. Because of the increased risk associated with these types of projects, the interest rate you receive on your construction-to-permanent loan may be higher.

This type of loan converts into a permanent mortgage once construction is complete. With this type of loan, you only have to pay closing costs once, reducing what you owe in fees overall. After the construction loan becomes a permanent mortgage with a term of either 15 or 30 years, your payments cover interest and the principal. You have the option to choose from a fixed-rate or variable-rate mortgage when the transition occurs.

Construction-Only

Construction-only loans provide funds to complete the building. Once construction is done, you are responsible for paying the loan or obtaining a mortgage to do so. With this type of construction loan, funds are dispersed as the project is completed, and you’re only responsible for paying interest on the money drawn. Most often, construction-only loans are tied to the prime rate plus a margin. As the prime moves, your loan interest rate is subject to increase.

When compared to construction-to-permanent loans, construction-only loans often end up being more costly. That’s because you’re paying for two separate transactions, which means more fees. Additionally, construction-only loans are a bit riskier than construction-to-permanent loans. If your financial situation changes throughout the construction process, you may not qualify for a mortgage once construction is complete and therefore you would be unable to move into your new home.

Qualifying for a Construction Loan

Lenders may be wary of providing a loan for an investment that doesn’t exist yet, which, in this case, is a house yet to be built. Before obtaining a loan, it’s important to understand the unique risks associated with construction loans. For example, changes in the market can drastically affect your ability to obtain a loan, as well as the interest rates you’ll have to pay. Another unknown factor with any new home build is how construction will go. Surprise costs can pop up or the builder could run into unexpected delays, costing you more money than you originally planned.

Find a Qualified Builder

Lenders must approve of the contractor or building company in order to grant a construction loan. Before applying for a construction loan, find a qualified builder to get the job done right. This will help eliminate potential problems and give the bank more of a reason to approve your loan. When you’re looking for a qualified builder, they should have the following qualifications:

  • Has at least two years of experience.
  • Currently holds at least $500,000 in commercial liability insurance.
  • Has a construction or contractor license.
  • Has a satisfactory credit history.
  • Can pass a background check.

Provide the Lender With Details

Once you find a qualified builder, you’ll need to provide a detailed list of what your construction will look like. This includes floor plans and an inventory of materials, the suppliers who are going to provide them, and any subcontractors hired to do work. Your bank will also want to see projections of the total cost of your project and what kind of profit your new construction will yield.

Credit Check

Your lender will request to see proof of income. They’ll also run a credit check to ensure you’re a reliable source of payment.

Have the Property Appraised

The construction loan you qualify for is based on the value of your completed home. Appraisals allow the bank to get an accurate idea of what your home’s value will be once complete, based on market conditions and the location of your build.

Make A Down Payment

Most lenders require a 20% down payment for construction loans. Some lenders may ask for as much as 25%. Your down payment depends on how risky the bank considers your construction to be.


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This post was updated October 31, 2019. It was originally published October 31, 2019.