Everything You Need to Know About Home Building Construction Loans

How to Pay for a Custom Home

Construction Loan vs. Permanent Loan (Mortgage)

Most individuals understand conventional home financing: make a down payment, secure a mortgage, and pay monthly for 15–30 years. Building on personal land requires two distinct loans: a construction loan and a permanent loan.

A construction loan comes from a bank rather than a mortgage company, as banks prefer short-term lending. The typical construction loan term is approximately one year, during which borrowers pay interest only. Upon completion, a permanent loan is obtained to pay off the construction loan.

Banks and mortgage companies within the same organization function as separate entities with different requirements:

• Debt-to-income ratio: Banks typically prefer this below 43%
• Cash down payment: Banks require more upfront cash than traditional home purchases

What the Bank Will Want to Know

Financing construction involves more scrutiny than purchasing an existing home. Banks may request additional years of tax returns, business tax returns (for self-employed individuals), and explanations of significant life events affecting financial history.

What Happens Once My Construction Loan Is Approved?

Following approval, the bank orders an appraisal — a professional valuation of the proposed home based on land location, house size, amenities and features, and recent comparable sales in the area. The appraisal determines lending capacity. Banks typically use this formula:

If a home appraises at $200,000, the bank lends $160,000. If construction costs $190,000, the borrower needs $30,000 in cash.

How Do I Pay the Builder as It's Being Built?

Builders receive payment in installments called "draws," corresponding to construction phases:

1. Builder completes a phase (foundation, under-slab plumbing, concrete slab)
2. Borrower pays an agreed percentage of total price
3. This repeats for each phase until 100% completion

Upon full payment, the permanent loan process begins. From the mortgage company's perspective, this represents refinancing of the construction loan rather than a new purchase.

How Do You Find an Experienced Builder?

Builder selection influences financing options. Many seeking construction loans discover banks reluctant to lend for residential projects. Banks consider builder reliability during underwriting because incomplete projects create significant risk.

Seek Out Longevity

New builders lack sufficient track records for banker confidence. Established, well-known builders with solid banking relationships expedite loan approval.

Find a Fixed Cost Builder Instead of Cost Plus

Fixed-cost builders guarantee a set price regardless of material increases. Cost-plus arrangements mean client prices fluctuate with material costs.

Appraisal Price

Cost-effective builders produce homes appraising above contract prices, giving clients immediate investment returns. Banks favor situations where appraised value exceeds actual cost, reducing their risk significantly.

How Can You Find an Experienced Banker?

Locating qualified bankers poses challenges comparable to — or exceeding — finding quality builders. Shopping for banks requires understanding what qualifies as a good fit.

Find a Bank Familiar With Construction Lending

Start by asking your current bank or local institutions. If loan officers lack construction-lending focus or cannot clearly explain processes, the bank probably doesn't handle many construction loans. Recommendations from builders or acquaintances who've built on personal land prove invaluable.

Don't Get Hung Up on Interest Rates

Construction typically takes approximately six months. Borrowing duration is brief, and interest accumulation is minimal.

Don't Let the Banker Boss You Around

You have the right to demand thorough explanations until satisfied. If bankers resist clarification, consult others. Even after identifying a satisfactory banker, consult one additional institution to confirm alignment.

Find Out Whether the Bank Has a Mortgage Department

Banks with mortgage departments may offer smoother construction loan processes and better terms. Since construction loans generate limited profit with substantial work, banks appreciate opportunities to also handle permanent mortgages.

Ask About Their Experience

Critical question: "Without naming names, can you tell me about the last construction loan you did for someone whose situation was similar to mine? Similar location, land type, house type and size, and budget?"

Red flags emerge when bankers claim processes remain identical regardless of location, land type, or budget. Positive indicators include specific stories addressing particular challenges.

A Real Life Example

A family nearly committed to another builder after applying for a construction loan with a bank specializing in such loans. The land sat in an established rural community with older comparable properties. Their new home featured amenities and energy-efficient components absent in older homes.

The Problem: The bank employed a formula designed for subdivision homes, lacking experience with rural properties. Their appraiser guessed conservatively. The bank declined without problem-solving.

The Solution:A different bank familiar with rural custom home construction recognized the property's unique value and client reliability.

Two Additional Critical Questions

1. Does the bank have to follow Fannie Mae and Freddie Mac guidelines?Banks answering "yes" may face overall loan limits for rural land homes, possibly disqualifying borrowers despite positive loan officer discussions.

2. What conditions apply to that high loan-to-value offer?Some bankers offer loans at 90–100% of appraised value, but such offers typically include significant conditions like requiring land ownership or extended ownership periods.

Best Banks for Construction Loans in Oklahoma City

Over 53 years of home building in central Oklahoma, we've worked with dozens of banks — some excellent, some acceptable, some problematic. Interest rate shouldn't be your primary decision factor.

Working With Your Bank

Selecting a bank doesn't guarantee approval. Loan officers initially offering positive assessments don't ultimately decide — underwriters do.

The Basic Process

1. Paperwork: Bank statements, W-2s, tax returns, supporting materials submitted to underwriters
2. More paperwork: Banks typically request additional documents 3–4 times during processing
3. Loan approval with conditions: Construction costs not exceeding specified amounts, appraised value meeting minimums, income stability, employment continuity

Why Does It Take So Long?

Government Red Tape

The 2008 housing crisis resulted in extensive federal regulations. Fee quotes must match final numbers exactly. Borrowers receive three-day review periods; any discrepancies trigger corrections plus another three-day review.

Hidden Processes at the Bank

Loan officers function as salespeople rather than decision-makers. They gather information and forward it to underwriters — the "man behind the curtain" scrutinizing details against bank and federal checklists.

Appraisal Basics

Construction loans require appraising homes not yet built. Appraisers estimate home values for banks considering them as investment collateral.

Low-Value, High-Cost Items

Certain features qualify as expensive but not significantly valued by appraisers. Basements exemplify this — expensive concrete excavation and walls creating rooms without adding significant appraised square footage. Wraparound porches present a similar challenge.

How Location Affects Appraised Value

Appraised values depend heavily on recent comparable home sales in the same general area. If nearby home values are low, lenders can't justify higher construction costs. Consider nearby home values when deciding building locations.

Three Main Appraisal Methods

1. Value comparison: Compares similar properties — the most commonly used approach
2. Cost approach: Estimates construction costs using national databases (not very accurate geographically)
3. Income approach: Evaluates income-generating potential (uncommon for residential homes)

Loan-to-Value Versus Loan-to-Cost

Bankers lending for construction determine specific loan amounts providing sufficient building funds while minimizing risk. Banks lend no more than a specified percentage — typically 80 percent of finished home value. This is called loan-to-value (LTV) of 80%.

Sometimes bankers discuss loan-to-value when actually meaning loan-to-cost. Example: Building a $200,000 home appraising for $220,000. Since 80% of appraised value is $176,000, some bankers will only loan 80% of cost ($160,000) instead.

How Much Cash Will I Need for a Down Payment?

Banks typically want 20% down of either the construction cost or the appraised value. If homes appraise for more than building prices, banks can lend 80% of the higher amount.

An Example

Your building contract specifies $250,000. The appraisal comes in at $270,000. Your banker lends 80% of $270,000 = $216,000, meaning you need $34,000 cash ($250,000 − $216,000). That's $16,000 less than if the house appraised for exactly the construction cost.

How Much Will My Payment Be Each Month?

Construction loans differ from familiar mortgage loans in two key ways: they fund in stages matching construction progress, and you only pay interest (not principal + interest).

When closing on a construction loan, you haven't borrowed money yet, so no interest accumulates initially. As phases complete, you draw from the loan and pay builders. Your interest payment grows as more money is drawn.

Example: $50,000 drawn of a $200,000 loan at 6% annual interest. 6% ÷ 12 = 0.5% monthly. 0.5% × $50,000 = $250/month. As you draw more, payments increase until the permanent mortgage pays off the construction loan.

Trick of the Trade

You can potentially finance interest payments. Banks calculate likely interest owed during the construction loan term and increase loan amounts accordingly. You're borrowing money to pay interest, but given the small amounts and brief periods, extra interest becomes negligible.

Keep Learning

Securing construction loans for homes built on personal land can seem overwhelming. Over 53 years building homes, we've helped hundreds of customers obtain construction loans, but banking industries evolve, and we continue learning too.

The information above should increase your confidence seeking construction loans and initiating home building projects. Our top recommendation: stay informed throughout every step. Find trustworthy builders and bankers with experience willing to share knowledge throughout the process.