What is a construction loan?

Key points

• A construction loan can help you finance the building of a new home on land you’ve already purchased.
• Depending on the situation, you may opt for a construction-only loan, a construction-to-permanent loan or another option altogether.
• Construction loans are typically more expensive and have stricter requirements than traditional mortgage loans.

If you can’t find a home that fits exactly what you’re looking for, building your dream home may be the right move. But it’s not possible to obtain a traditional mortgage loan on a home you haven’t built yet. Instead, you’ll want a construction loan.

A construction loan is a type of financing that you can obtain to cover the cost of building your custom home. These loans typically have a repayment term of one year or less, during which you only have to make interest payments.

Once that period is up, you may obtain a traditional mortgage loan to pay off the construction loan, or your construction loan may convert to a traditional mortgage loan.

How does a construction loan work?

A construction loan is a short-term loan that works similarly to a mortgage loan in that it uses your property as collateral. You can use the funds to purchase the land, cover permits and materials and pay for contractor labor.

You’ll typically need to provide the lender with a timeline of the project, along with a budget. The lender will then pay out the loan funds in stages as different phases of the project are completed.

However, construction loans typically have variable interest rates, which fluctuate with market rates. You’ll typically make interest-only payments during the initial period, after which the principal balance of the loan will come due. Then you’d begin submitting principal-and-interest dues.

Because there’s no home at the beginning of the process, construction loans are riskier for lenders than regular mortgage loans, so you can expect a higher interest rate.

Depending on which type of construction loan you obtain, it may automatically convert to a traditional mortgage loan, rolling that balance into a 15-to-30-year repayment term, or you may need to apply for a new mortgage to pay off the construction loan.

Types of construction loans

There are a few types of construction loans from which you can choose. Below is a quick summary of your options.

• Construction-only loan: With this option, your loan is only available for the materials and other expenses required to build the home. Once the repayment period is up, you’ll need to obtain a traditional mortgage loan to pay off the construction loan, which means you’ll incur two sets of closing costs.
• Construction-to-permanent loan: With this loan, you’ll get the funds to complete the building of the home. Then, once you’re ready to move in, your loan will automatically convert to a mortgage loan, which typically spans 15 to 30 years. “A construction-to-permanent loan makes sense when the home you want to build is large, unusual or uncommon,” says Tom Bond, construction sales manager for Planet Home Lending. “Those types of homes [often] aren’t eligible for conventional financing.”
• Owner-builder loan: With this option, you’re building the home on your own rather than working with a contractor. That said, you’ll likely need some licensing as a contractor to obtain this type of loan. Otherwise, you may have a hard time finding a lender willing to offer you financing.

Pros and cons of construction loans

Construction loans have both benefits and drawbacks to consider. If you’re thinking about using one to finance the building of your new home, here’s what to keep in mind.

Pros

• Project-based financing: Depending on what you want to do with your dream home, you may find a lender that’s willing to be flexible with your timeline and needs.
• Interest-only payments at first: During the construction process, you only have to pay interest on the loan, giving you some flexibility with your finances. That room in your budget might be particularly useful if you borrow a construction loan while paying a mortgage or rent payment for an existing property.
• Supports your dream: Because you can’t get a traditional mortgage loan when constructing your own home, the process would be cost-prohibitive without construction loan options. “A construction loan lets you buy the exact home you want in the exact place you want to live,” says Bond. “You don’t have to go with a builder’s design in a subdivision or purchase an existing home.”

Cons

• Can be costly: Because construction loans carry more risk to the lender, they typically come with higher, variable interest rates. And if you don’t opt for a construction-to-permanent loan, you’ll end up with two sets of closing costs.
• Funding depends on progress: Instead of getting a lump-sum payment, you’ll get multiple draws from your construction loan as the project progresses. If you or the contractor don’t stick to the timeline, it can delay funding and cause headaches.
• They aren’t as common: You shouldn’t have too difficult a time finding local and national lenders that offer construction loans, but they aren’t as ubiquitous as traditional mortgage loans, so you may not have as many options to compare.

Construction loans vs. mortgage loans: What’s the difference?

While construction loans are specifically designed to pay for the building of a home, a mortgage loan helps you finance the cost of buying a home once it’s been built. Here are some of the main differences between the two options:

	CONSTRUCTION LOAN	MORTGAGE LOAN
Repayment term	One year or less	Up to 30 years
Interest rate	Variable	Fixed or adjustable
Minimum credit score	Usually 680-plus	As low as 580
Down payment requirement	Usually 20% or more	As little as 0%

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Frequently asked questions (FAQs)