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- If you need financing to build your own home, you can get a short-term construction loan.
- You'll likely only pay interest on the loan until construction is completed.
- When building is finished, you can convert or refinance the loan into a regular mortgage.
When you need financing to buy a home, you get a mortgage. But what if you're building your own home? Then you'll need a separate type of loan called a construction loan.
What is a construction loan?
Construction loans are short-term loans used to fund the building of a home.
While mortgages can come with terms of around 30 years, construction loans terms are usually around a year. The lender charges an adjustable rate that is higher than what you'd pay on a regular mortgage.
How do construction loans work?
Unlike a mortgage, a construction loan only covers costs associated with building the house, including the following:
- Land
- Permits
- Building materials
- Labor
- Contingency reserves, or an extra chunk of money in case your costs are higher than what you expected
There are a few different types of construction loans, but they generally work in one of two ways: either your construction loan will convert to a mortgage once the home is finished, or you'll need to use a separate mortgage to pay off the construction loan
Types of construction loans
Construction-to-permanent loan
With a construction-to-permanent loan, you'll roll the construction loan into a regular mortgage once the building is complete.
You'll probably only pay interest during the construction period, and it will be an adjustable-rate loan.
Once construction concludes, the loan will be converted into a regular mortgage that has either an adjustable or fixed rate. Then you'll start making monthly payments that include both the principal and interest.
If you choose a construction-to-permanent loan, you only have to apply for one loan, and you'll only pay one set of closing costs.
Construction-only loan
With a construction-only loan, you get a standalone construction loan that doesn't convert into a regular mortgage later.
Your lender will probably only require you to pay interest during the building period. Once construction is complete, you'll pay off the principal in one lump sum, generally by refinancing into a regular mortgage.
Not all lenders offer construction-to-permanent loans. So if you know you want to use a certain mortgage lender but it doesn't have construction-to-permanent loans, you might choose a construction-only loan.
This type of loan does have its drawbacks, though. Because you have to get a mortgage separately from your construction loan, you'll have to go through the application and approval processes more than once. You'll also have to pay two sets of closing costs.
End loan
End loans go hand-in-hand with construction-only loans. The end loan refers to the long-term, permanent mortgage that replaces your construction-only loan once the house is completed.
Owner-builder construction loan
You'll apply for an owner-builder construction loan if you, the borrower, are the one doing the construction. Many lenders don't approve this type of loan. If you want to build the home yourself, you'll need to have a license and work in construction for a living to be approved.
Renovation loan
You might want a renovation loan if you're buying a home that already exists, but it needs significant repairs or rehabilitation.
With renovation mortgages like FHA 203(k) loans, renovation costs are wrapped up in the mortgage, so you only have to apply for one loan and pay closing costs one time.
The projects you can use these types of mortgages for depends on your loan. Conventional renovation loans typically have more freedom, while FHA renovation loans can't be used for "luxury" projects, like putting in a new pool (though you can repair an existing one).
Renovation loans can come in other forms, such as a personal loan or home equity loan.
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Eligibility and requirements for a construction loan
Understanding the eligibility criteria
As with a regular mortgage, a lender will look at certain aspects of your financial profile to determine whether you qualify for a mortgage. Exact eligibility requirements will vary by lender, but you'll probably need the following:
- Credit score: 680 or higher
- Debt-to-income ratio: 45% or lower
- Down payment: Minimum 20% for a construction-to-permanent or construction-only loan, although some lenders require more. For a renovation loan, you can probably put down much less. For example, if you get an FHA 203(k) loan, you'll only need a 3.5% down payment.
Necessary documents for applying
In addition to the usual documentation you'll need when applying for a mortgage — which includes things like W-2s, paystubs, tax returns, and bank statements — you'll also need to give the lender any documentation related to the construction of the home. This includes your contract and detailed plans for the project.
The importance of a detailed construction plan
When you apply, the lender takes a deep dive into your plans, finances, and builder. Construction loans are risky for lenders, so they examine these factors thoroughly.
Your approval could partly depend on your builder. Be sure to choose a builder who has a credible work history and is known to finish projects on time. Make sure you're both on the same page about the expected budget and timeline.
Applying for a construction loan
The application process for a construction loan is similar to applying for a mortgage. But in addition to scrutinizing your finances, the lender will also scrutinize the plans for the build and take into account the likely future value of the property being constructed.
Some of the lenders we've reviewed that offer construction loans include:
You may also want to see if a local bank or credit union offers these types of loans. Talking to a local lender can be helpful if you're just starting out, since they may have recommendations for good local home builders if you aren't already working with one.
You can also search the National Association of Home Builders' directory to find your local association and find a builder through them.
Tips for a successful application
You'll want to give your lender a detailed picture of what the home building process is going to look like, how long it will take, and how much it's going to cost. This means being prepared to provide things like blueprints, floor plans, and a list of needed materials with costs.
You'll also want to make sure you have plenty of cash saved up for your home build. Not only will you need a hefty down payment, but the lender may also want to see that you have extra funds available in case the project goes over budget.
Managing your construction loan
Draw schedule and disbursements
When you apply for a construction loan, you'll give the lender your project timeline. The lender gives money to the builder, not to you, in installments for each stage of the building process according to your timeline.
You'll probably hear the lender refer to these payment installments as "draws." An inspector or appraiser will need to evaluate the construction before each draw is approved. Then, the money will be disbursed to cover the costs of completing the next leg of the project.
How interest-only payments work
Most lenders only require you to pay interest on the loan until construction is complete. It depends on the loan and the project, but your home may be scheduled to be completed in about a year.
Transitioning to permanent financing
If you have a construction-to-permanent loan, your loan will convert to a mortgage once construction is finished. Otherwise, you'll need to apply for a mortgage once your home is nearing completion. This mortgage will pay off the construction loan, and you'll transition to making regular mortgage payments that include both principal and interest.
Risks and considerations
Common risks associated with construction loans
One of the biggest issues with construction loans is that construction projects don't always go according to plan. If construction takes longer than expected, you could end up paying to extend the construction loan. If it goes over budget, you could have to cover the extra costs out of pocket, cut costs in other areas, or see if you can qualify for a larger loan.
Another risk is that your finances change during the construction period and you're no longer able to qualify for a mortgage. This can happen if you have a construction-only loan and need to qualify for a separate mortgage, or if the lender of your construction-to-permanent loan needs to re-check your credit and income before the loan converts.
It's also possible that you end up with a construction loan balance that exceeds the value of the newly-constructed property.
Alternatives
For a process that's less involved and potentially less expensive, you might consider buying a new construction home rather than financing your own custom build. With a new construction property, you're buying from a builder or developer that's responsible for purchasing the land and securing the financing for construction.
Depending on the type of new construction you're buying, you may have some say in what the home looks like and how it's laid out.
What are construction loan rates?
Construction loan rates are adjustable, meaning your rate will fluctuate according to the index it's tied to (such as the prime rate).
Construction loan rates are typically higher than mortgage rates. This is because mortgages use the home as collateral, which makes the loan less risky for the lender. But with construction loans, the home hasn't been built yet, so there's no collateral to collect if the borrower isn't able to pay back the loan.
Fortunately, you may be able to get a lower permanent rate once you convert or refinance into a regular mortgage.
Construction loan FAQs
With a construction loan, there's a risk that the project costs more or takes longer than initially planned, which could end up being expensive for you. It's also possible you'll no longer qualify for a mortgage once the project is finished.
A construction loan typically has a term of one year, while the average mortgage is 30 years. While the home is being built, the borrower will make interest-only payments. Once the home is completed, the borrower will pay off the construction loan, often with a permanent mortgage or the proceeds from a previous home sale.
Typically, you'll need a credit score of at least 680 to qualify for a construction loan, but some lenders may require even higher scores.
It's much easier to get a loan to buy a home than it is to build a house from the ground up. Construction loans are generally riskier, harder to qualify for, and more expensive.
The only way a bank will let a borrower act as their own general contractor is if they're a professional working in construction and they're getting an owner-builder construction loan. Banks generally won't lend to a layperson looking to build their own home.
You can use a construction loan to buy the land to build your home on.
You'll need an experienced home builder to create a detailed plan for your home so you have an accurate estimate of how much it will cost you each month when you ultimately get a mortgage on the property. You should also plan for monthly interest payments while construction is ongoing.
If you go over budget on a financed home build, you'll need to cut costs elsewhere, cover the extra costs out of pocket, or talk to your lender about borrowing more money.
If you just want to rehab a home rather than build a new one, a renovation mortgage or personal loan might be better. Alternatively, you can purchase a new construction home instead of a custom build and use a regular mortgage to finance the purchase.
