Construction Loans: Building Your Dream House

Finding the perfect home is typically easier said than done. For some homebuyers, using a loan to build their house instead is an opportunity to get everything they want. Before you start breaking ground on your new house, it is important to understand how the different types of home building loans work, and what they cost.

What is a construction loan?

A construction loan covers the cost of building or renovating a house. They can be used to finance a completely custom house—designed and built based on your specifications—or to pay for major renovations on an existing home. These loans typically have shorter terms (one year or less) compared to traditional mortgages. Your chosen lender will disburse the money in installments as construction work on the property progresses. After the building is complete, your home construction loan will need to either be converted to a mortgage loan or paid in full.

Every home building project is unique, but in general, a construction loan will pay for:

• Land or property

• Permits, fees, and planning

• Labor and materials

• Contingency reserves (in case the project costs more than originally anticipated)

The disbursement of funds from the loan happens in phases, rather than the transfer of a single lump sum. Your lender will pay the builder or contractor in installments known as “draws.” Each draw will coincide with every important phase of construction, such as pouring a foundation, framing the home, and any finishing work.

Note: During the construction or building phase the borrower will typically pay only for the interest on the loan, however, you should carefully review the terms of the loan.

Types of construction loans

There are a few different types of construction loans you can choose from, including:

Construction-to-permanent loans—These loans finance the construction of a new home, then convert to a permanent mortgage once the house is completed. Best for borrowers who want to save on closing costs and lock in mortgage financing.

Construction-only loans—These are short-term loans used to complete construction of a new house. Once construction is completed, this type of loan must be paid in full or a new mortgage loan obtained. This means that you may be required to go through two application and closing processes. Best for borrowers with a large amount of cash on hand or those intending to pay off the loan with funds from the sale of their previous home.

Owner-builder loans—With this loan, the lender will disburse the funds to the borrower rather than an approved third-party contractor. It’s only available to homeowners who can prove they have experience as a home builder or have their own contractor’s license. Best for homeowners with experience building homes and want to act as their own general contractor.

Renovation loans—A home renovation loan is a form of financing that includes funds for upgrading, remodeling and repairing an existing home. There are many types of renovation financing loans so it is best to discuss options with your chosen lender. Renovation financing may be best for homeowners buying a fixer-upper and intending on investing in big renovations.

Getting a construction loan

Obtaining a construction loan is similar to the steps it takes to secure a mortgage loan. First, it will be essential to get your finances in order—this will allow you to determine what you are able to afford. Minimum requirements for construction loans vary based on the type of financing

The next step is shopping for a lender. Not every lender offers construction loan products. Do your research and seek out referrals. Often times, local builders will be able to recommend lenders they have worked with on past projects. Once you have found a trusted lender, you will need to have all of your financial information ready in order to get pre-qualified. This will give you an estimated loan amount and terms the lender may approve.

Once you have secured pre-qualification from your lender, it is time to hire a builder. Normal mortgages are transactions that only involve a lender and a borrower. However, construction loans have an added third party: a licensed builder. Your construction loan will depend on your contactor’s ability to complete construction plans on time and within the budget. It is vital to take your time researching and interviewing contractors so you can be sure you hire the right one for the job. Once you have found a builder and put together a detailed plan for construction, you can submit it to your lender for approval!

Then it is time to get pre-approved. For this step, your lender will ask for more financial documentation and will verify your information, as well as confirm construction plans. If all looks good, you will be approved to start construction!

Construction loan rates

Interest rates for construction loans vary based on your creditworthiness, the size of the loan, and its terms. However, construction loan rates are typically variable. This means that the rate will adjust throughout the course of the loan based on an index, like a prime rate.

Usually, these rates are about one percentage point higher than standard mortgage rates. Since construction loans are not secured by an already existing home, they are riskier investments for lenders compared to traditional mortgages.

When to use a construction loan

If you are interested in building your dream home from the ground up, a construction loan may be worth considering. Be sure to take stock of your current finances and research lenders who offer these types of loans. You should have a clear picture of the end goal of your building project. Remember that building a home takes time, a significant amount of funds, and careful planning.