How Do Construction Loans Work?

Learn how a construction loan can help you build a home.

Home is where the heart is — and if you’re going to be spending years or even decades of your life in one place, you want it to fit you to a T. If your real estate agent can’t find a home that meets your needs, you can always opt for building a home, which would ensure it meets your specifications.

You might not have the funds to cover the cost to build a house, however, and traditional mortgage lenders might not be willing to lend you money for undeveloped land. If building a house is for you, you might need a construction loan, which is a loan that will cover your costs while you’re building.

Read on to learn how construction loans work and use the information to decide whether it’s best for you to buy or build a house.

What Is a Construction Loan?

A construction loan is a short-term loan that provides capital for you to pay for your new home’s construction. Typically, you’ll pay higher interest rates for a construction loan than for a traditional mortgage and you’ll need to put down a much larger down payment — often 20 to 30 percent.

A larger down payment and higher interest rates give the lender additional protection in case you walk away before construction is complete. Construction loan terms are generally just long enough to complete building a home — usually between six and 24 months.

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The Construction Loan Process

Applying for a construction loan is a more arduous process than applying for a mortgage. And you’ll need to budget for your down payment because construction loans generally require much larger down payments than mortgages. For example, you might need to make a down payment between $60,000 and $90,000 on a $300,000 construction loan.

You’ll have to include the cost of the land when you’re figuring how much your home will cost. If you already own a home, talk to your lender to find out if you can wait to sell your current home until after you complete your new home or if you’ll need the proceeds of your current home to serve as part of your down payment.

When you apply, gather your financial documents. You’ll need to provide proof that you’re financially able to take on the loan with documents like your tax returns and W-2s. You’ll also need to provide your lender with some additional documents, including:

  • Your builder contract
  • A floor plan
  • The land contract to purchase the lot
  • A deed if you already bought the land
  • The builder’s certification, licenses and insurance coverage

Apply for loans with multiple lenders so you can get the best interest rate and terms. Different banks might offer fixed- and adjustable-rate loans, so explore the type of loans available to you to find out which will best fit your needs.

A construction loan can be a conforming loan or a nonconforming loan. The latter is a loan that exceeds the FHA loan limits, which vary by location. Due to the additional documents the bank must review, expect approval to take a few weeks, not seven to 10 days like a traditional mortgage.

Construction Loan Time Line

Construction loans are usually designed to last only for the duration of construction. Typically, your lender will make periodic disbursements to the contractor as he hits different building benchmarks.

While your home is being built, you make interest-only payments on the funds you have borrowed up to that point. For example, if your construction loan has a credit limit of $400,000 but the bank paid the builder only $100,000 to the builder so far, you’ll pay interest only on $100,000.

Understand: The Basics of How an Interest-Only Mortgage Works

When the construction is finished, you usually have to pay the construction loan off in a lump sum or refinance it into a new loan. Because you haven’t been paying down the principal of the loan during construction, this might come as a bit of a shock.

Construction-to-Permanent Loans

To avoid worrying about applying for another big loan in just a few months when your construction is finished, consider going with a lender that offers a construction-to-permanent loan. Some banks allow you to automatically convert your construction loan into a permanent mortgage once your home is built.

A bank will require an inspection after the construction is complete to confirm the home meets occupational standards. In addition, the bank will ask for a certificate of occupancy and a lien to release the builder, as well as a homeowner’s insurance policy.

Find Out: How to Get the Best Mortgage Rate

Build Your Dream House

If you’re hoping to build your dream house but don’t have the cash to pay for it upfront, a construction home can help you break ground. Remember, however, that the construction loan will usually cover only the building phase — you’ll need to be ready to refinance into a more traditional mortgage once construction is completed, unless you find a lender who will approve you for a construction-to permanent loan.