What Is a Home Construction Loan, and How Is it Different From a Conventional Loan?

By: , Contributor

Published on: Feb 07, 2020

This is how you finance your dream home.

When your goal is to build a home from scratch, the process is going to be a bit different than if you had chosen to buy an existing home -- especially where construction financing is concerned. You'll need to apply for a home construction loan, rather than a conventional one.

Learn what a construction loan is, how it works, and how it differs from a conventional loan option. This post will also cover common construction loan terms as well as the ins and outs of how to get a loan of your own. Use this information to help you get started on the road toward building your dream home.

What are the different types of home construction loans?

Put simply, a construction loan refers to any loan used to cover the cost of building or majorly rehabilitating a home. Presently, there are three different types of construction loans to choose from:

  • Construction-to-permanent loan: With a construction-to-permanent loan, you borrow the funds, as needed, to build your home. Then, when construction is complete, the loan is converted to a traditional mortgage, which you can then pay off over time. The biggest advantage of this type of loan is that you only need to close on the loan once, which can save you lots of money in closing costs.
  • Construction-only loan: With a construction-only loan, the loan must be paid off in full once the construction of the home is complete. It's mainly used by those who have lots of cash on hand or who are confident that the proceeds from the sale of their old house will totally cover the cost of the new build. In this case, if you need to mortgage the cost of the construction, you'll need to reapply and requalify for a new loan to cover the balance.
  • Renovation loan: Renovation loans, or home improvement loans, are slightly different from the two other types of construction loans. These loans are used for existing homes that need a lot of work. Here, the projected cost of any necessary renovations is wrapped up in the mortgage along with the purchase price. Unlike with the two other types of construction loans, government-backed programs (like those through the Federal Housing Administration) are available for rehabilitation loans, which can make qualifying easier.

What should I consider when thinking about a construction loan?

The loan term

Home construction loans are generally considered short-term loans. Their loan terms typically last between six months and a year in an effort to keep the construction timeline from lagging. After that point, the construction loan will either need to be paid off in full or converted into a traditional mortgage.

The disbursement arrangement

With a typical home sale, the principal loan amount is simply paid in one lump sum at closing. With a new-construction home, the loan process works a little differently. Instead of being paid out all at once, the loan amount is distributed in installments, which are known as "draws."

Each draw will cover a distinct phase of building. Before each draw is disbursed, the construction loan lender will send out an inspector to estimate the cost of the work being done. Once the work is completed, the draw will reimburse the builder for it, meaning that they -- or you -- need to have enough money to cover the cost of the project upfront.

That's why it's so crucial to work with a builder with enough experience to ensure that their projects come in on budget.

The payment schedule

Typically, when you make a payment on your mortgage, you're paying both the principal amount and the interest on a loan. However, during the construction phase, an equal housing lender will likely only ask you to make payments on the interest on the loan. After construction is complete, you'll either be expected to pay the loan off in full or, at that point, the loan will convert into a permanent mortgage.

How do I qualify for a construction loan?

Every lender is different, so the exact requirements of your loan may vary. That said, here's a general overview of the criteria you will likely need to meet to be approved for a construction loan:

  • Debt-to-income ratio: Fortunately, the debt-to-income ratio that you need to meet to be approved for a construction loan is fairly similar to the requirements for a standard home loan. You should aim for a ratio that is less than or equal to 45%.
  • Credit score: However, the credit score you need to get a construction loan is typically higher than you would see for your standard mortgage. Most lenders require a credit score of 680 or higher to approve you for a construction loan.
  • Down payment: The down payment requirements for construction loans are also higher. You'll want to be prepared to put down between 20% and 30% of the cost of the home build.
  • Savings: Similarly to a standard home loan, you'll need to have a few months of cash reserves left in savings after making your down payment. However, if you're using a construction-only loan, your lender may also ask you to prove that you have enough cash on hand to pay off the balance of the loan once construction is complete.

How can I get a home construction loan?

For the most part, getting a new home construction loan is very similar to qualifying for a traditional mortgage loan. You'll apply for the loan, and the lender will vet your finances to ensure that you meet their underwriting criteria. That said, you'll likely also have to provide the lender with additional documentation related to your construction team and the build itself.

To start, your lender may want to vet the builder. They may request to see your builder's work history and proof of insurance. Then, in terms of the build, the lender may ask to see a schedule for the work, blueprints, specifications, and a budget.

What if I don't qualify?

If you don't qualify for a home construction loan, there are a few other financing options to consider:

  • Home equity loan: A home equity loan works very similarly to a traditional mortgage, except that you're borrowing against the equity you've built up in your home. In this case, you'll be given the money in one lump sum and you'll be expected to make regular payments on both the principal and the interest of the loan.
  • Home equity line of credit: As the name suggests, a home equity line of credit works similarly to a credit card. However, these loans often come with a much better interest rate than a credit card. Here, you'll be given a certain amount of time where you can borrow against the equity in your home, as needed. During that time, you'll likely only need to pay the interest on the loan. After your borrowing period is over, that's when you'll need to pay back the principal and remaining interest on the loan.
  • Look for a local mortgage lender: Sometimes smaller, local lenders will offer portfolio loans or have more flexible qualifying standards than bigger branches.

The bottom line

Financing new construction may be different from buying an existing home, but it can be done. Once you understand what a home construction loan is, as well as how to qualify and what you'll need to apply, you're well on your way to building the home you've always dreamed of.

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