How do Home Construction Loans Work?

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Point of Interest

If you’re looking to build a house, it’s important to know that home construction loans are shorter in length and considered higher risk by banks than a standard mortgage.

Many of us dream of building our perfect home from start to finish, but then we run into the financial side of things. Home construction loans are more challenging to get than a standard mortgage because they’re considered riskier. Plus, a construction loan lasts for about a year, while a mortgage can last for 30 years. They’re very different beasts. Learning about how home construction loans work can help you decide if they’re right for you.

Types of construction loans

  • Construction-only loans — These loans cover only the construction of your home and must be paid off in full after the house is finished. You’ll either have to pay the full amount due or transfer the total to another mortgage. Thus, you’ll pay closing costs twice: once when you get the loan and again when you move it to a standard mortgage. Also, your interest rates will be variable for this loan, but you can always refinance at a later date.
  • Construction-to-permanent loans — This type of loan is best for convenience since your construction loan transfers into a standard mortgage at the end of the build — without paying closing costs a second time. Plus, you can lock in interest rates early, so you have steady payments. The bank pays the contractor as they build, and that full amount turns into a mortgage.
  • Renovation construction loans — This type of construction loan is used to rehabilitate your home’s existing structure. You can use it to purchase a house that needs renovation, and the cost of remodeling gets included in the mortgage. This funding comes from government programs, home equity lines of credit, or personal loans (if it’s a small enough amount). These loans allow you to take out less debt than a typical mortgage.
  • Owner-builder construction loans — If you’re a licensed tradesperson, you may be able to act as the builder of your home as well as the owner. Most banks don’t offer these types of loans unless you can prove you have the necessary skills and licenses to complete the project on time and budget. But it could be a great choice if you’re looking to build your home with your own two hands.

How do construction loans work?

If you have a plot of land waiting for you to build on, you’re lucky. Most people don’t have this convenience, so they have to buy the land at the same time as building their home. Therefore, many construction loans cover the cost of the property you need to buy in addition to the home building costs. A construction loan is not a mortgage, but instead, a short-term loan that lasts for the time it takes to build the house. The total loan amount is based on the projected future value of the home once it’s built.

You can use home construction loans for building or renovating your home. Unlike other types of loans, like personal loans, the bank pays out the money to the builder in installments rather than in one lump sum. The bank will want to inspect your home at each installment to make sure construction is on track before dispersing more funds. It then transfers the full cost to you once the build is complete. Having the bank track the building process may sound like a drag, but it can help keep things on schedule.

During construction, you only pay interest, so you have more time to save some cash. However, if you own a home, you may have to sell it before applying for a home construction loan, especially if you still owe a significant amount on your home. You’ll need to prove that you can afford to take on more debt and keep up with your current bills, which is more of a challenge with an ongoing mortgage.

How to get a home construction loan

Lenders are more hesitant to give out a construction loan than a standard purchase mortgage because it’s a riskier deal for them. But that doesn’t mean you can’t get one.

With this type of loan, you don’t have your home as collateral (since you haven’t built it yet), so you need excellent credit. Banks typically look for credit scores above 680, but if you’re looking into a Federal Housing Administration (FHA) loan, you could qualify with a score of 620. Also, you’ll need to prove you have a reliable income.

Additionally, before you apply for a construction loan, you’ll need to put in quite a bit of legwork. You’ll need to tell the bank:

  • Who will build your home.
  • What size the house will be.
  • What materials you’ll use.
  • How much it will cost to build.

In other words, you’ll need to meet with a general contractor before applying for the loan. They can help you work out the details of what to expect during the home building process.

A home construction loan will have a slightly higher interest rate because of the higher risk involved. Building up your credit and improving your debt-to-income ratio can help you get more competitive rates.

The final word

Deciding which type of construction loan is best for you can be tricky. A construction-to-permanent loan is convenient (and has lower fees) because it transfers automatically to a standard mortgage, but a construction-only loan lets you decide whether to pay off the building loan in full or transfer the amount owed to a mortgage. On the other hand, if you’re buying a fixer-upper, you can take out smaller home construction loans, which you might prefer. Even better yet, if you can build a home yourself, there are loans custom-made for you.

Home construction loans can be intimidating, but if you take it one step at a time, you’ll soon have the funding to build your dream home.

Tiffany Verbeck

Personal Finance Contributor

Tiffany Verbeck is a personal finance expert. She uses her storytelling skills gained from a master’s degree in writing to run a freelancing business focused on helping people make and manage their money.