When you're building a home, understanding the ins and outs of construction loans is key. You’re likely familiar with permanent loans—commonly referred to as a 30- or 15-year mortgage. These are long-term loans used to finance the purchase of a finished home, but a construction loan is a different animal entirely.
In this post, we’ll break down what a construction loan is, why you might need one, and how the process works.
A construction loan is a shorter term loan used to finance the construction of a new home—and you’ll need one building a home on land you already own. It uses that land and future home as collateral, so it’s taken in your name (as the property owner).
In some cases, a builder may suggest temporarily transferring ownership of the land to them, so they can secure the loan in their name. This can cut through red tape and ensure the loan is approved faster, if they have an established relationship with a bank.
However, you shouldn’t make this decision lightly, as it does carry a risk: if anything happens to the builder, you could potentially lose your land.
While both construction loans and mortgages help finance a home, they have some major differences in how they work. Let’s break it down by looking at the similarities first, then diving into the key differences.
Similarities:
Both types of loans require a thorough review of the borrower’s financial background, including income, debt, assets, and credit history. The lender wants to make sure you can afford the loan.
In both cases, the lender will assess the property’s market value. This ensures that if you default, the lender can recover most of the loan amount by selling the property.
Whether you’re applying for a mortgage or a construction loan, the borrower must have full legal ownership of the property. This protects the lender by ensuring there are no legal claims from someone else on the property.
Differences:
Type of Lender and Loan Process: Mortgage loans typically come from mortgage companies and are often sold to investors like Fannie Mae or Freddie Mac. This allows mortgage lenders to follow specific rules that might allow them to lend up to 97.5% or even 100% of the property’s value, depending on the program.
Construction loans, on the other hand, usually come from local banks. Since these banks keep the loans on their books, they follow different regulations and are more conservative, typically lending only 80-90% of the appraised value.
Risk and Requirements: Construction loans are riskier for banks since the home hasn’t been built yet, which means more variables could go wrong. Because of this, construction loans usually have stricter requirements, such as lower debt-to-income ratios. Mortgages, since they’re for a completed home, generally have more flexible lending terms.
Loan Disbursement: With a mortgage, the full loan amount is given at once when you purchase the home. With a construction loan, however, funds are released in stages, as the home is built. This “draw schedule” ensures that money is only paid out for work that has been completed.
Payments: For a mortgage, your monthly payment includes both the principal and interest, gradually reducing the total loan amount over time. With a construction loan, you typically only pay interest on the amount that’s been disbursed so far, with the full principal being paid off once construction is complete and you switch to a permanent mortgage.
Term Length: Construction loans are short-term, usually lasting around a year, with the option to extend if needed. Mortgages, on the other hand, are long-term loans, often ranging from 15 to 30 years.
The requirements for getting a construction loan can vary depending on the bank or credit union. Credit unions often have different federal requirements than banks, which means they may offer more flexible terms and qualifications. However, most lenders generally ask for similar things when reviewing your application for a construction loan.
Here’s what you can typically expect:
Income Verification: You’ll need to provide proof of income, such as W-2s or tax returns.
Job Stability: Lenders typically want to see that you’ve been in the same job (or at least the same line of work) for the last two years.
Debt-to-Income Ratio: This is a key factor in determining your eligibility for a construction loan. Lenders want to ensure you’re not overburdened with debt.
Credit Report: While your credit score gives a quick snapshot, lenders will often dive deeper into your full credit history to evaluate your financial health.
Down Payment and Closing Costs: You’ll need to have cash or equity for the down payment and closing costs.
Understanding these requirements will help you get a better idea of what to expect. Keep in mind that construction loan rates may vary based on the lender’s assessment.
Banks and credit unions are common places to get a construction loan, but not all lenders are the same. A lender’s ability to offer construction loans often depends on the experience of their team and local factors—such as the property appraisers they use.
For example, if you're building in a rural area, it’s important to choose a lender that has experience with construction loans in that region. They’ll be familiar with the challenges of appraising rural properties and how to account for unique variables like land size and lack of nearby comparables. Additionally, the lender’s construction department staffing can impact the level of service you receive, including how often they can conduct progress inspections in line with your draw/payment schedule.
The best approach is to talk to lenders recommended by your trusted builder. Builders have firsthand experience working with construction lenders and can help steer you away from any potential issues they’ve encountered in the past. Keep in mind that each lender may offer different construction loan rates, so it's important to shop around to find the best fit for your project.
Need more details? Download our free eBook to learn more about how a construction loan works when you’re building on your own land.