Construction Loans 101: Everything You Need To Know

The US housing stock is aging into disrepair, with the median age of a home nearing 40 years old, according to data from the National Association of Home Builders. It is thus, not surprising that homeowners looking for their dream home are considering either building one from scratch, or undertaking an extensive renovation project.

Here is a general guide on construction loans, the various types, and how to apply for one...

Person viewing a floor plan for a house with a hard hat

What is a construction loan?

A construction loan is a short-term loan secured by the property which is used to finance the land, materials, and labor required to build a new home.    

How is a construction loan different than a home improvement loan?

A home improvement loan can be either an unsecured personal loan or a home equity style loan. The loan sizes are smaller than construction loans because the funds are intended to be used for smaller one-off projects.  

How do I know which type of loan I want?

Among other things, you will want to look at the rate, term, and conditions of the loan to help choose which loan is right for you. 

If you are building a new home, you will likely need a construction loan to be able to have enough funds to complete the project. Your choices would be between a construction loan, a personal loan, and a home equity loan or first mortgage taken against another property, if you own one. If you don’t own another property with excess equity available, then this won’t be an option for you. 

The benefits of a personal loan and a home equity loan are that -

i) lenders typically will disburse the funds directly to you and give you control over how you spend it on your project, and

ii) the term is generally longer than a construction loan term. 

The negatives are that personal loans can carry higher rates because of this flexibility. 

Home equity loans are generally the best choice if you have available equity in an existing home, with a combination of relatively low rates, long terms, and flexible use of proceeds. However, new home construction is expensive and it could be difficult to cover it using the equity in another property. As a result, you will need to find the best possible construction loan to fund your expenses.   

What are the different types of construction loans?

1. Construction-to-permanent loan

Construction-to-permanent loans combine construction financing and mortgage financing into one loan.

In other words, with a construction-to-permanent loan, you borrow money to pay for the cost of building your home, and once the house is complete and you move in, the loan is converted to a permanent mortgage. 

Generally this is a “single-closing” transaction, with one lender providing the entire solution and the terms are locked-in upfront, which protects you from rising interest rates. 

The construction loan is generally a 1-2 year loan where you make interest payments along the way but no principal payments. When the project is completed, it becomes a permanent mortgage — typically with a loan term of 15 to 30 years — and you make payments that cover both interest and the principal.  

2. Construction-only loan

A construction-only loan provides the funds necessary to complete the building of the property, but the borrower is responsible for either paying the loan in full at maturity (typically one year or less) or obtaining a mortgage to secure permanent financing. 

Similar to a construction-to-permanent loan, the funds from these construction loans are disbursed based upon the percentage of the project completed, and the borrower is only responsible for interest payments on the money drawn. 

Construction loans are considered riskier for the borrower because your financial situation might worsen during the construction process making you unable to qualify for a mortgage to repay the construction loan; this could force you to sell the newly constructed house to pay off the loan, or find some other means of repayment. 

Both types of construction loans require a down payment from the borrower. For the builder to start construction, the down payment funds are drawn on first. Once the down payment funds are exhausted, you can begin drawing funds from your construction loan to pay construction costs. 

Interior of house being built with framework

How is applying for a construction-to-permanent loan different from applying for a mortgage?

The application process for a construction-to-permanent loan and traditional mortgage financing is very similar. 

However, unlike a traditional mortgage, you’ll also be asked to provide documentation related to the construction, such as the contract you’ve signed with the builder, the construction plans and specifications. 

The construction agreement with your builder usually must specify the cost of your home including options, upgrades and lot value. You will also likely need a copy of the floor plan and facade of the house, if applicable, and a deed to the lot. 

The approval process might take a little longer because of the additional information that needs to be reviewed.

How is construction loan money disbursed?

Funds are released to the builder as different phases of the project are completed. The lender will order inspections to have an independent confirmation of the progress of the work and determine whether the next set of funds can be disbursed. 

Who makes construction loans?

Most banks and lenders that make traditional mortgages also offer some type of construction loan product. You can also check with your home builder to see if they recommend any particular financing options. Some examples of lenders offering construction loans are below:

1. Citizens Bank

2. US Bank

3. First Republic

Read Next: Equal Credit Opportunity Act: Know Your Rights

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