How Do Construction Loans Work?
Written by
Daria Uhlig
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Melanie Grafil
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A construction loan provides short-term financing for building a new home or renovating an existing home you’re purchasing. Loan terms are usually 12 to 18 months, during which time you make interest-only payments. After that, the loan either automatically converts into a mortgage loan or you refinance it with a mortgage loan.
What Is a Construction Loan?
A construction loan covers the cost of construction permits, labor and materials for a new home construction or a home renovation. The loan can also finance the cost of the lot.
Payments on Construction Loans vs. Mortgages
Unlike a mortgage loan, which pays out all at once, a construction loan is paid out in a series of draws against the principal amount as construction reaches certain milestones. You make interest-only payments until the work has been completed.
Repaying Your Construction Loan
How you repay the loan depends on the type you have.
- Construction-only loan: You’ll apply for a separate mortgage loan and use the proceeds to repay the construction loan.
- Construction-to-permanent loan: The construction loan automatically converts into a mortgage. This type is sometimes called a single-closing construction loan.
Because you don’t have to apply for a separate mortgage, you won’t have to worry about closing a mortgage loan or paying a second set of closing costs.
Example: How a Construction Loan Works in Practice
Say you’re working with a building contractor to purchase a lot on which you’ll build a custom home.
If the lot is $100,000 and the home itself, including permits, labor and materials, is $400,000, you’ll need $500,000 for the project.
A 20% deposit is $100,000, and this leaves $400,000 to be financed. The loan proceeds go into an escrow account the builder will draw from to build the house.
Your contract with the builder will include a schedule for these draws and, and it typically requires the homeowner to sign off on each after the lender’s inspector has confirmed that the work has been completed.
The draw schedule might look similar to the one below, from the Mutual Savings and Loan Association:
- Draw 1: Due after land survey and preparation are complete and the builder has poured the foundation..
- Draw 2: Due after the framing is complete and windows and exterior doors have been installed.
- Draw 3: Due after the exterior has been primed for painting and plumbing, electric and HVAC have been roughed in and the roof is complete..
- Draw 4: Due after the exterior is complete and kitchen and bath cabinetry has been installed.
- Draw 5: Due after plumbing, electrical and HVAC work is complete, appliances have been installed and the lot has been graded and cleared of debris.
- Draw 6: Due after a final inspection and issuance of the occupancy permit to the homeowner.
During construction, the homeowner makes interest-only payments on the amount drawn. If the loan is a construction-to-permanent loan, it automatically converts to a mortgage after the last draw. Otherwise, the homeowner takes out a mortgage loan and uses the proceeds to pay off the construction loan.
Pro Tip
Stay in close contact with the builder and the lender while construction is underway, and inspect the work at each stage before signing to release the next draw.
Pros and Cons of Construction Loans
Construction loans make it possible to build a new home you can’t afford to pay for out of pocket, but it’s important to understand the drawbacks before you decide to use one.
Pros
- You can purchase a custom-built home on a lot you choose.
- You typically make interest-only payments on the outstanding balance.
- In most cases, the loan automatically converts to a mortgage, so you only have to close once.
Cons
- Compared to mortgage loans, construction loan rates are usually higher, and the loans are harder to qualify for.
- You’ll have several documentation requirements and will have to do a lot of follow-up to apply for and close a construction loan.
- Construction projects are subject to unexpected delays and cost overruns.
Construction Loan vs. Mortgage: What’s the Difference?
Construction loans and mortgage loans both help buyers finance home purchases, but that’s where the similarities end.
Here’s a comparison of the two loan types.
| Feature | Construction Loan | Mortgage Loan |
|---|---|---|
| Purpose | Purchase — Build a new home or renovate one you’re buying | Purchase an existing home |
| Payout | In draws as construction reaches scheduled milestones | Lump-sum disbursement at closing |
| Term | Short term, usually 12 to 18 months | Long term, usually 15 or 30 years |
| Interest rates | Usually higher | Usually lower |
| Credit and income requirements | Strict | Less strict |
| Minimum down payment | Usually 20% to 25% | Usually 5% |
| Collateral | Future home | Existing home |
What You’ll Need To Get a Construction Loan
Applying for a construction loan is different from applying for other loans you might’ve taken out, including mortgage loans.
Here’s what you’ll need.
- Construction loan preapproval: Research lenders to compare loan offerings and rates, and request a preapproval from the one with the best loan. A preapproval indicates that you have a good chance of being approved, and it tells you how much you’re likely to qualify for — an important factor in planning your construction budget.
- Reputable builder. The lender will need to approve your builder, so look for one with experience and positive reviews. Also, search builders on your state’s licensing board website to make sure they have a valid contractor’s license and no disciplinary actions. The National Association of Home Builders is another excellent resource for vetting builders.
- Detailed building plan and construction timeline: You’ll submit these documents and your construction contract with your construction loan application.
- Good credit: Lenders typically require a credit score of 620 or better for a construction loan.
- Proof of income: W-2 forms, pay stubs, 1099s, bank, investment and benefit statements and tax returns are some of the documents the lender might ask for to verify your income.
- Down payment: Most lenders require 20% to 25% down.
Is a Construction Loan Right for You?
A construction loan is just one way to finance a home purchase, so it makes sense to think through the decision to make sure it’s the right one for you.
A construction loan is a good option if:
- You want to build a new home or renovate an existing one
- You have a reputable building contractor and a detailed construction plan and timeline
- You’ve been preapproved for a loan and have the cash for a down payment
A construction loan is not ideal if:
- You want to move in quickly — it takes an average of seven to 14 months to build a home, according to Angi.
- You’re uncomfortable with work involved in planning your build and handling the lender’s documentation requirements.
FAQs About Construction Loans
Unlike a traditional mortgage, a construction loan funds your project in stages. Learn how construction loans work with these frequently asked questions.- Can I get a construction loan with bad credit?
- Some lenders offer bank statement loans that they approve based on income instead of credit. They're considered non-qualified loans, and they're best used as business loans rather than residential ones.
- How much down payment do I need?
- Lenders usually require 5% to 20% down for a construction loan.
- What happens if the project goes over budget?
- If your construction project goes over budget, you'll need to pay the additional amount out of pocket or take out an additional loan.
- Do I need to own the land first?
- No. You can use your construction loan to finance your land purchase.
- Can I act as my own contractor?
- You may be able to act as your own contract if you can prove to the lender that you have sufficient contracting experience.
Our in-house research team and on-site financial experts work together to create content that’s accurate, impartial, and up to date. We fact-check every single statistic, quote and fact using trusted primary resources to make sure the information we provide is correct. You can learn more about GOBankingRates’ processes and standards in our editorial policy.
- U.S. Bank. "Construction loans."
- Mutual Savings and Loan Association. "Sample Construction Disbursement Schedule."
- American Express. 2024. "Construction Loan vs. Mortgage: What’s the Difference?"
- National Association of Home Builders. "National Association of Home Builders."
- Angi. "How Long Does It Take to Build a House From Start to Finish?"
