What is a Home Construction Loan and How Does It Work?
If you’re considering building your dream home instead of buying an existing one, you’re probably going to need a construction loan unless you plan to pay in cash.
Construction loans work differently from traditional loans, and we’ll delve into those differences as we explain what a construction loan is and how it works.
In this article:
- What is a home construction loan?
- How do home construction loans work?
- Types of home construction loans
- What are the requirements for a construction loan?
- Why should I get a construction loan?
- Questions to ask construction loan lenders
What is a home construction loan?
A construction loan is a loan that covers the cost of building or renovating a home. Unlike a traditional mortgage, it’s a short-term loan, usually for less than one year. Plus, rather than lending the entire balance of the loan at one time, a construction loan pays a series of advances, more commonly called “draws,” as the home is being built.
Home construction loans can be used to purchase land and build a home, or construct a home on land you already own. You can also place a manufactured home on land with construction financing.
How do home construction loans work?
New home construction loans work very differently from regular mortgage loans. During construction, interest-only payments are commonly made on the balance of the money you’ve drawn. The loan is designed to pay the contractors and subcontractors in regular installments based on how much of the work has been completed at each stage of construction.
Once the newly-built home is complete, the loan is paid off or converted into a “permanent” loan, which works like a traditional mortgage with principal and interest payments.
Here are some important mechanics you should understand.
The loan is paid in small lump sums called draws
New-house construction is completed in phases. Because your home’s value is contingent on it being completely finished, new home construction loans are paid after each completed phase of building.
In order to keep the home build moving along, the lender disburses smaller lump sums, called draws, to you and your general contractor to pay all of the parties working to complete your home. The typical construction mortgage is designed with a five- to seven-draw schedule, although there can be many more for complex projects.
The table below provides an example of the most common work completed for a typical seven-draw construction loan schedule.
How the draws are paid
There are two methods used to pay the draws. One disburses money each time a new phase of the work is substantially completed, such as when the foundation or rough framing is completed. The other is based on a percentage of completion of a particular line item. Here’s an overview of each method.
Substantial completion phase of work
This is the most common type of draw payment. Money is paid out when significant parts of the homebuilding process are completed.
Percentage of completion
The other method of draw disbursement is based on how much of any particular phase or line item is completed. This may be more common with a custom home, where certain parts of the construction process are much more costly than others.
For example, the framing of the home is often one of the biggest expenses since it involves paying for the bulk of the lumber and labor early in the process. Your contractor might ask for a draw once the framing is 50% complete to make sure there is enough money to pay workers to finish the framing on a home with a much larger square footage, or if more expensive specialized materials are being used, such as steel framing instead of wood.
Types of home construction loans
Construction lenders provide different types of loans for a variety of homebuilding scenarios. Here are the key features of the different types of construction loans.
One-time close construction loan
A one-time close construction loan is more commonly referred to as a construction-to-permanent loan, because the construction loan is converted to a regular or permanent mortgage once your home is complete. There is only one approval process, and the terms of the final loan are known before construction begins.
Borrowers make interest-only payments during the construction phase, and then make traditional principal and interest payments once the home is complete, and the permanent loan is put into place.
Two-time close construction loan
This type of construction loan requires closing on two different loans. The first loan is taken out for the construction of the home, and any applicable payments will be based on the balance used.
Once construction is completed, the construction loan is paid off with a new loan, often called an end loan. The end loan is made based on terms locked-in as the home nears completion — great news if rates are dropping, but stressful if mortgage rates increase while construction is underway.
One challenge many homeowners face is cost overrides, such as a sudden spike in the cost of materials or a specialized room layout that requires more specialized labor than expected. With a two-time close construction loan, you can increase the final loan amount to cover the additional expenses, as long as you document them.
Owner-builder construction loan
When you’re building a home, one of the biggest expenses is hiring a general contractor to supervise the homebuilding process. If you already have some specialized knowledge or expertise in construction, you may consider an owner-builder loan.
With an owner-builder loan, you act as the general contractor and handle all the related tasks. As long as you can prove you have the background and experience necessary to get lender approval and have the budgeting skills to manage all phases of construction, an owner-builder mortgage could give you much more control over the building process.
Pros and cons of different construction loan types
The table below lists the pros and cons of each type of construction loan listed above to help you decide which is the best fit for your new homebuilding finance needs.
|Construction loan type||Pros||Cons|
|Construction-to-permanent (One-time close)||
What are the requirements for a construction loan?
When you get preapproved for a mortgage on an existing home, lenders are mostly concerned with whether you can afford to repay the loan based on your credit, income and assets. An appraiser is hired to inspect the home and verify that the value supports the sales price.
With a construction loan, the house hasn’t even been built so the lender needs to perform an extra analysis to confirm the building costs are not excessive. Your lender also wants to ensure the contractors are qualified and legally licensed.
Follow these three steps to get approved for a construction loan.
1. Credit approval
Just like a standard loan, the lender will need paperwork from you proving you have the ability to repay the loan. Many people mistakenly assume a construction loan down payment of at least 10% to 25% is needed.
Government loan programs offered through the FHA, VA and USDA offer construction loan options with as little as a 0% down payment. You may have to shop around more to find a local lender offering government-backed construction loans, but it may be worth it to keep down payment and closing cost expenses to a minimum. Below is a brief overview of the borrowing requirements for each option.
|Construction loan program||Minimum down payment||Debt-to-income ratio maximum||Minimum credit score||Loan amount restrictions|
|FHA||3.5% if a HUD-approved project
10% if not HUD-approved project
|43% recommended||580||County limits based on ZIP code|
|VA||0%||41% recommended||No minimum score but 620-640 recommended||VA loan limits for the area|
|USDA||10%||41% recommended||620||Must be a USDA-eligible property|
|Conventional||5%||45%||620||Fannie Mae and Freddie Mac only fund permanent loans|
2. Project approval
The lender will need to review a blueprint of the house to ensure the home is being built in a workmanlike manner and meets all the local building codes. The home appraiser will need a copy of the plans and specs to review when formulating an opinion of value.
Construction lenders restrict how much they will lend on your home compared to its value, which is known as the loan-to-value ratio, or LTV. The LTV maximum is based on the home’s value or the cost to build, whichever is less, and you have to pay the difference out of pocket if your cost to build exceeds the LTV guidelines.
3. Builder approval
The final stage of construction loan approval involves a contractor, or in some cases, the approval of more than one contractor if they are all involved in various stages of construction. The Federal Trade Commission (FTC) recommends getting several written estimates from different firms and checking to make sure the contractor you choose has a current license.
In most cases, lenders require completion of a builder approval package listing past building experience along with financial documents, including tax returns, current licenses and proof of different types of liability insurance. Lenders want to prove that the builder has sufficient insurance in the event a worker gets hurt to protect you from any on-site worker injury claims.
Why should I get a construction loan?
You don’t necessarily have to get a construction loan to build a new house. In most cases, you can avoid the extra hoops by buying a home in a subdivision built by a particular homebuilder.
In these cases, the builder carries the cost of construction and you don’t make any payments while it’s being built. Normally, you just have to be preapproved for the end loan and put down a deposit.
As easy as this may seem, there are a number of reasons why you may not want to buy a home in one of these neighborhoods, and get a construction loan instead.
You don’t like preplanned homes in subdivisions
When builders construct homes in neighborhoods, there are restrictions on how they want the neighborhoods to look, with very little variation offered as far as layout, colors and landscaping. The neighborhoods are often governed by homeowners associations requiring an approval process before making even minor changes to your home.
You want custom features or a unique layout
The reason most people choose a construction loan to build their home is to create something tailor-made to their needs. Building on your own land without the interference of an HOA gives you more freedom to make your house exactly the way you want it.
You want more land than home
Buying a large parcel of land off the beaten path can be appealing if you enjoy the serenity of a natural setting, or if you don’t want any homeowners association restrictions on your property. If you own a recreational vehicle, it probably wouldn’t be allowed on a lot in a subdivision neighborhood.
A construction loan will give you extra flexibility to purchase the land and build a home with all the privacy and independence you want.
Questions to ask construction loan lenders
You may need to shop around for a home construction loan lender. The best place to start may be at your local bank. You might also want to ask the builder or contractor you are working with to recommend a construction lender they’ve worked with in the past.
Take the extra time to research what each construction loan program can and can’t do, what the timeline is for completing a project, how long you can lock in your rate and whether you can float the rate down when you get closer to your home’s completion.
Here are a list of questions you should ask any construction loan lender you talk to.
Can I use my land equity toward my down payment?
If you’ve owned the land you’ll be building on for at least 12 months, you may be able to apply any increase in your equity toward the down payment requirement. An appraisal will need to be done to verify the land’s value.
Does the first draw allow for payment for materials to start construction?
In the early stages of construction, building materials, such as concrete for the home’s foundation and lumber for framing often make up the biggest expenses. However, lenders don’t like to make large disbursements unless they’re designated for a specific expense.
This deters unscrupulous contractors from demanding large sums of money without specifically designating them for precise expenses related to your project. Make sure that there are enough funds available for the builder to break ground, and that you and your contractor have a clear understanding of how all construction funds will be paid.
What’s the interest rate during construction and how is it paid?
Some construction lenders will use a variable-rate index like the prime rate during construction. Others charge interest-only on the rate that you’ve locked in for your end loan and then convert the balance to a full principal and interest payment when the home is finished.
In some cases, the payments during construction can be financed into the construction cost of your loan — be sure to check with your construction loan officer to confirm that.
Do you offer a one-time or two-time close construction loan?
Not all lenders offer each type of construction loan, and nonbank lenders may not offer construction loans for new homebuilding at all.
What are the fees for your construction loans?
You need to know more than just the lender fees. The title company will often handle the disbursements, and you’ll have additional inspection fees and recording fees along the way as the house is being built.
Each draw requires inspection and recording fees, and those can quickly add up to thousands of dollars, so make sure you have a clear understanding of what’s included in the costs.
Do you pay construction draws based on a set schedule or a percentage of completion?
Make sure your contractor or builder understands how they will be paid during the construction phase to prevent any delays in the process. If a subcontractor flat out refuses to any work until they receive an upfront payment, come up with the cash to cover the front money the contractor asks for, or find a different subcontractor.