Home Construction Loans Explained

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There’s nothing quite like building your home from the ground up.

Building from scratch can let you skip some of the hang-ups of a previously occupied residence, like termites, water damage, unintuitive room layouts, or disastrous wallpaper. You can start from a clean slate.

Of course, you’ll have to pay for it, and one way to finance that kind of project is with a home construction loan. 

Construction loans are popular for building new-construction homes — but you’ll have to factor in the strict financial and construction underwriting processes and potential delays due to COVID-19.

What Is a Construction Loan?

A home construction loan is a short-term, high-interest loan that finances the costs of building a new home. After the home is constructed, you need to either pay off the loan or fold the amount borrowed into a traditional 15- or 30-year mortgage, either with the same lender or a different one. These loans have loan terms of one year and generally cover the costs of land (unless you already own it), labor, materials, closing costs, and permits. Funds are typically disbursed to the building contractor directly instead of the homeowner — even though the homeowner will ultimately be responsible for paying back the construction loan once the home is built. 

How Do Construction Loans Work?

Construction loans are used to fund either a brand-new home or substantial renovation, such as a new roof or a kitchen remodel.

In general, lenders consider these types of loans as riskier investments. Unlike a standing house, a bank’s appraiser can’t physically inspect and evaluate the property with new construction. “They have to appraise based on what they’re reading on a piece of paper,” says Michael Foguth, president and founder of Foguth Financial Group. And it’s even more difficult for custom-built homes versus pre-existing, proven designs.

To offset the risk, interest rates for construction loans (usually variable) are higher than those for conventional mortgages, since banks consider building a new house riskier than purchasing an already-constructed house. You’ll likely have to make a down payment between 20% and 25%, too. 

The process for approval is also a lot tougher. With traditional mortgages, your home is the collateral, and banks have recourse (i.e., repossessing the house) if you’re unable to repay it. With a home construction loan, you get approved based on the strength of the blueprint, the viability of the construction timeline, and the reputation of your building contractor. During the application process, the lender relies heavily on your contractor providing a detailed construction plan, timeline, and budget for the project. 

After the loan is underwritten — if you’re approved — the lender would disburse partial funds to the builder in accordance with the construction timeline. Afterward, you’re expected to pay interest only on the loan during the construction phase. 

After construction is completed, you’d either enter a repayment period (and have two separate mortgage payments) or convert the loan into a traditional mortgage, with the construction loan payments folded into your monthly mortgage payments. Both Foguth and Reyes recommended the latter option (called a construction-to-permanent loan), for the convenience of a single payment and undergoing the underwriting process and paying closing costs only once. 

How the Pandemic Has Affected Construction Loans

Construction is taking longer than usual because of the COVID-19 pandemic, as the Washington Post reported in June. Labor is harder to source, housing supply in high-demand areas is already tight, and materials may be delayed or in shortage because of other disruptions in the supply chain. In some jurisdictions, quarantine mandates that were put into effect in response to coronavirus outbreaks have stalled construction altogether.

Residential construction is down year-over-year, though banks did increase lending in the second quarter of this year after the initial wave of COVID-19 outbreaks, according to a report from S&P Global. In the same period, banks recorded a high of $850 million in residential construction loan delinquencies.

Types of Construction Loans

There are five main types of home construction loans, all of which vary in terms of affordability, interest rates, and eligibility requirements. Here’s what you should know about each of them.

1. Construction-to-permanent loan

Also known as a C2P, one-step, or single-close loan, a construction-to-permanent loan finances both the construction costs and the permanent mortgage. So instead of taking out two separate loans (in which you’d have to pay two sets of closing costs), your loan would convert to a 15- or 30-year mortgage once construction is complete.

2. Construction-only loan

A construction-only loan is a short-term loan that pays only for the costs of building a home. At the end of the loan (typically one year), you’ll either have to repay the loan in full or refinance it into a separate mortgage. A downside here is that you’ll have to undergo the loan underwriting process twice and pay two sets of closing costs.

3. Renovation loan

A renovation loan is for homebuyers who want to rehab new fixer-upper homes with a loan that folds building costs into the mortgage. But unlike other renovation financing methods (second mortgages and cash-out refinancing), which require little-to-no oversight, renovation loans undergo the same scrutiny as other construction loans. The lender vets your contractor, budget, and construction timeline — and doles out funds to the builder according to the draw schedule if you’re approved.

4. Owner-builder construction loan

Owner-builder construction loans are subsets of construction-to-permanent or construction-only loans in which the homebuyer is acting as the building contractor themselves. “You’ll need to have certificates and licenses to prove you’re competent at building this house” for this type of loan, says Mark Reyes, CFP, financial advice expert at Albert, an automated money management and investing app. Foguth adds if you haven’t had significant experience building homes before, the likelihood you’d get approved for a construction loan is “zero.” 

5. End loan

An end loan is another term for the mortgage taken out once construction ends. It’s considered the mortgage that the construction loan converts to after the house is completed and construction ends. An end loan can also refer to a separate, long-term refinance that a homeowner may use to repay a construction loan, in lieu of repaying all at once.

Pro Tip

Verify that your building contractor is licensed and insured before agreeing to work with them. You can also check their reputation through your state’s consumer protection agency and the Better Business Bureau.

What to Consider When Getting a Construction Loan

Interest rate

Construction loans generally have adjustable rates that scale up and down based on the market. Given the loan term is typically a year, you likely won’t experience too much fluctuation. But keep in mind that construction loans tend to have higher rates than mortgages for existing homes, as the lender is shouldering more risk by trusting that the home will be built correctly and on schedule. 

Large lump-sum costs

Most lenders will expect a minimum down payment of 20% or more for a construction loan. And if you go with a construction-only loan, you’ll be expected to repay the loan in full once the home is built or refinance the costs into a separate mortgage or end loan.

Construction plans and timeline

Your building contractor will play a key role in the loan-underwriting process. The contractor will have to present the building blueprint, schedule, and budget to your lender, where it will verify the plan is comprehensive and safe and evaluate the likelihood you’ll pay the loan back at the end.  

Make sure you have a realistic schedule and budget in place for the project, factoring in enough time to account for possible delays. Your timeline can be affected by seasonality, what’s available in your area, and the pandemic as a whole, Reyes says. “If you’re starting in the winter, will snow and rain affect the feasibility of this and push it out another season? Is there a shortage of supply, like cedar or studs, in your area? Will you have to import materials?”

Knowing what issues you could run up against will help set expectations for the construction process — and it could help mitigate delays that could force an extension on your loan.

How to Get a Construction Loan

Qualifications

Eligibility standards for a home construction loan will vary by lender, but generally, you’ll need to meet the following criteria:

  • Employed with a steady income
  • Low debt-to-income ratio (45% maximum)
  • Good-to-excellent credit score
  • Down payment of at least 20%
  • Approval of contractor, budget, and timeline

Finding a lender

Regional banks and credit unions are often your best bet for a home construction loan, Reyes says. They tend to offer competitive rates and have pre-existing relationships with builders in your area, which can make the construction underwriting process go more smoothly.

You’ll want to go with a lender that has experience underwriting construction loans for people who have been in similar situations as you, as your experience with a lender may differ depending on the type of home you’re constructing. 

“If you’re doing a custom home, you’re going to want to interview the bank as much as they’re interviewing you,” Foguth says. “If you’re building a standard subdivision home, where there may be a hundred of them [built] already, go with the same bank that’s done all of them. They won’t put you through the construction underwriting process, just the financial underwriting.”