How Do Home Construction Loans Work?

Learn about the options for financing your soon-to-be-built home.

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Building a brand-new home sounds like a dream to most people but it is possible. Home development can be long-winded and understanding home construction loans isn’t any easier. That’s why we created a guide to help you understand how home construction loans work.

If you are looking for a loan to help you finance the construction of a home, then the first thing you need to know is that home construction loans are typically harder to get approved for than a regular mortgage, according to U.S.News.

To chalk it up, home construction loans are inherently riskier, there are fewer lenders willing to offer them, and the lenders that do have stricter requirements for approval.

While this may make it harder for borrowers to get this kind of financing, the fact that the bar is being set very high is a good thing, both for lenders and borrowers.

How do home construction loans work?

Construction loans are a short-term financing solution for consumers who want to build their own home. These loans typically have terms of up to one year and come with variable interest rates which are generally higher than those of a standard mortgage loan.

After being approved for financing, borrowers receive a bank-draft schedule that releases funds to the builder as the project meets certain milestones. Throughout the construction phase, borrowers generally make interest-only payments. When the construction is complete, the borrower then rolls over the balance into a standard mortgage loan.

Some borrowers also have the option of getting a construction-to-permanent loan.  These products are basically two loans rolled into one: a construction loan and a mortgage. In this case, when the construction phase is complete, the lender automatically converts the balance of the loan into a standard mortgage.

There are quite a few different types of home construction loans for borrowers to consider.

Types of home construction loans

1. Construction-to-permanent loan

Construction-to-permanent loans help finance the building of a home and converts to a permanent mortgage after — with a loan term of 15 or 30 years (fixed-rate or variable rate).

This type of construction loan is beneficial for most people since only one set of closing costs has to be paid. Typically, home buyers will pay between about 2 to 5 percent of the purchase price of their home in closing fees. Having to buy for this settlement fee twice doesn’t set will in my stomach. Typically, for first-time homeowners who want a new home and will require a mortgage, this will be the best option.

2. Construction-only loan

A construction-only loan will finance the building of a home however does not convert to a permanent mortgage after. The borrower will be required to pay for the full loan amount at maturity, which is usually a year or less, or take out a mortgage loan from another lender to cover the loan.

With this type of loan, the loan amount is paid out in accordance to the construction timeline. Once projects are complete, more funds are doled out. The borrower is only responsible for making interest payments on the funds that have been disbursed.

These types of loans go for the current prime rate plus 2 percent more. Therefore, expect the interest rate to fluctuate with the current prime moves.

If you need a mortgage afterward, it’s generally better to get a construction-to-permanent loan so you can avoid paying for costly closing costs twice. Also, if you do require a loan afterward but face financial burdens, you may not be approved for one and face financial stress.

3. Renovation loan

Renovation loans come in many different packages, if you need a smaller amount like $15,000 then you can opt for an unsecured (personal) loan, using a credit card or taking out a home equity line of credit (HELOC). As the required amount becomes higher, the financing will be more similar to a mortgage.

Smaller renovation loans are easier to obtain and lenders are not as strict with doling out financing especially if the borrower have good credit.

4. Owner-builder construction loans

Owner-builder construction loans are used when the borrower is also the home builder. If the borrower is a licensed builder by trade, this is the type of construction loan that is used.

5. End loans

End loans are simply mortgages that are utilized after the construction loans are used. Once the home building process is done and the construction loan has been paid off, an end loan is used which is just a regular 15-to-30 year mortgage.

What’s required for a home construction loan?

While most borrowers wouldn’t exactly be feeling a sense of comfort when faced with the long list of requirements they need to fulfill in order to get a construction loan, the truth is they should.

To see why, here is a rundown of the main things that most construction loan lenders will ask borrowers to provide:

  • Construction specifications: Lenders will want a borrower to provide floor plans, information on the materials being used, and a list of all the contractors and subcontractors that will be working on the project.
  • A professional appraisal: The project’s specifications must be evaluated by an outside appraiser.
  • A qualified general contractor: This person is typically a licensed builder with a good and established reputation.
  • A detailed construction timetable: This time table will include major project milestones that will help the lender to decide on the bank-draft schedule.
  • A budget of estimated construction costs: This will be a breakdown of costs associated with the construction including materials, equipment expenses, and the cost of labor.
  • A stable income, good credit, and solid banking history: This helps lenders to verify that the borrower has the means to repay the loan.

Now, it is easier to see why such strict requirements are a good thing, not just for the lender, but for the borrower, too. From the lender’s perspective, they are considering as many factors as they can to help ensure that they don’t lose their investment.

The same is true for the borrower. Building new home is a complex process that relies heavily on the skill and expertise of the professionals hired to do the job, and, as mentioned above, there is a very real risk that not all will go according to plan.

Circumstances can and often do unexpectedly change along the way. The strict requirements that come with a home construction loan force borrowers to seriously consider the whole process and ensure that they not enter such an agreement unless they have done their due diligence and truly have the means to repay the debt.

What can go wrong when getting a home construction loan?

A borrower has an unexpected financial emergency, such as medical issues or the loss of a job that severely impacts the individual’s creditworthiness or income. This could make getting a mortgage at the end of the construction phase extremely difficult if not impossible.

Another common scenario is that a home is built using a construction loan, but the property ends up being worth less than the total construction cost. This can easily happen for a couple of reasons: there is a big, unexpected change in the local housing market or the builder does a poor job and/or uses inferior building materials.

Lastly, there are huge cost overruns and delays in the construction process. While all construction projects will hit a snag here and there and should be budgeted as such, sometimes unexpected factors can come up.

Some common examples include problems with sub-contractors or equipment, the problems with the delivery and quality of building material, the quality, and state of the ground on which the home is being built, and even that the borrowers change their minds about what they want to be built.

Why are they risky for lenders and borrowers?

There are a number of reasons why construction loans are inherently risky to both lenders and borrowers. Most importantly, unless borrowers own another property, they do not yet have a physical home that can be used as collateral during the construction phase. This means if circumstances change for the worse, whether for the borrower or with the construction process itself, and the loan cannot be repaid in full, then the lender does not have a built property it can use to recover some of its losses. The borrower also has no equity to tap into in order to cover the shortfall.

PBCL Staff
PerfectBadCreditLoans.com is the authority on bad credit, featuring daily articles, studies, guides, reviews and other resources for people with poor credit ratings.

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