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How Construction Loans Work
A construction loan is a short-term mortgage that enables a borrower to finance the cost of building a new home or significant renovations including for a tear-down or fixer upper. Construction loans are typically six months to a year in length depending on the schedule to build or remodel the property. Most construction loans are interest only mortgages so the borrower pays only interest and no principal over the course of the mortgage. Although the interest rate on a construction loan is typically higher than the interest rate on a regular mortgage, the mortgage payments are lower because the borrower only pays interest. Please note that the outstanding principal balance of the mortgage is not reduced with an interest only mortgage.
When the property construction or renovation is completed the borrower pays off the construction loan typically by refinancing it with a permanent mortgage. In many cases the construction loan lender also provides the permanent loan. If the construction loan lender does not provide permanent mortgages they usually require that the borrower has arranged a lender to provide the permanent mortgage before finalizing the construction loan.
Instead of arranging two separate loans it typically saves the borrower money and time to obtain a construction to permanent (C2P) loan which enables you to finance construction or renovation costs with one mortgage instead of two
The downside to a construction loan is that you have to apply for the permanent mortgage after the construction is complete. Your financial or employment circumstances may have changed over the course of construction which may make it more challenging to qualify for the permanent mortgage. Additionally, interest rates may have increased during the construction process which makes the permanent loan more expensive. To avoid these complications, we recommend that you arrange the permanent mortgage at the same time as the construction loan or apply for a construction to permanent loan or C2P loan, which is a single mortgage that includes both loans.
Instead of receiving the full proceeds from the construction loan immediately after the mortgage closes, the proceeds from the loan are disbursed, or drawn down, over time based on the financing required to complete the construction. This draw down mechanism helps reduce financing costs for the borrower during the construction phase because you only pay interest on the funds you have drawn down as opposed to paying both interest and principal on the total amount of the construction loan.
For example, a borrower may obtain a $250,000 construction loan but only receive $25,000 initially when the mortgage closes based on the amount of work expected to be done within the first month of the project. In this case, for the first month, the borrower will only pay interest on the $25,000 initially drawn down as opposed to paying interest and principal on the full $250,000 loan amount, which saves the borrower a significant amount of money.
Use the FREEandCLEAR Lender directory to find top-rated lenders that offer construction loans.
The draw down schedule is typically agreed to by the lender, borrower and contractor before the loan closes and reflects the construction timetable and financing requirements for the project. Additionally, in most cases lenders require ongoing inspections at each stage of the construction process before releasing additional funds to the borrower. The inspections ensure that work on the construction or renovation project is proceeding according to the plans and timetable originally submitted by the borrower and that all contractors are being paid as the project progresses. Lenders may not release additional disbursements if there are liens on a property such as a claim from an unpaid contractor. Please note that inspections are performed to verify the progress of the project and not the quality of the construction or renovations. It is up to borrowers to make sure that the quality of the work meets their standards.
When all of the planned work is finished, a final inspection is performed to confirm that construction is completed and the inspector issues a certificate of occupancy verifying that the property is suitable to live in. The lender also confirms that there are no outstanding liens on the property. At this point, the borrower repays the construction loan in full, typically by refinancing it with a permanent mortgage.
Not all lenders offer construction loans but many do. The best lenders for construction loans include:
- Regional banks
- Credit unions
- Banks that you have an existing relationship with including having a checking, savings or investment account with the bank
- Specialty lenders that focus on construction loans
Contact the lenders listed in the table below to determine if they offer construction loans. We recommend that you compare multiple mortgage proposals as construction loan terms vary by lender, project and other factors.
The qualification requirements for a construction loan are different than for a standard mortgage and include significantly more documentation, as you would expect. Lenders require that borrowers submit a detailed plan and schedule for the new property construction or renovation. Borrowers may be required to submit foundation reports, property surveys, engineering studies and architectural plans. In many cases borrowers are required to re-submit reports and surveys upon completion of the project to verify proper construction.
Borrowers typically are required to work with a licensed contractor or builder who is approved by the lender. The lender may require the contractor to sign the loan agreement that outlines the key construction mortgage terms including the schedule of disbursements. Given how construction loans work it is crucial that the borrower, lender and contractor are in total coordination on the budget and time frame for the project. Making sure that the contractor and other third parties are paid on time helps keep the project on track.
The lender also reviews the construction plans to make sure that you are budgeting sufficient funds to complete the project. The last thing the lender wants is to provide a construction loan that does not cover the full project cost. Most lenders also require borrowers to add a buffer or cushion to the loan amount to account for unexpected costs. Building a home or making major renovations almost always takes longer and costs more money than anticipated. Adding the buffer to the construction loan helps ensure that project is completed according to plan.
When budgeting construction or renovation costs, borrowers should build-in a 10% - 15% cushion to account for cost overruns and unplanned expenses
Most construction loans require a down payment of 20% to 25%. We should highlight that the required down payment is based on the total building cost according to the plans you submit and not the post-construction property value. For example, if the total building cost is $100,000 and you are required to make a 25% down payment, you need to put down $25,000 to qualify for the construction loan. Please note that the value of the land the property is built on -- less any loans against the land -- can be used to meet the down payment requirement. So if you own a parcel of land free and clear, the entire value of the land can be used for your down payment on the construction loan.
Borrowers are also required to meet the lender’s qualification guidelines including credit score and debt-to-income ratio requirements. Lenders want to make sure that you can afford the construction loan payment, especially because you usually do not live in the property while it is being built which means you have an additional housing expense. Borrowers should make sure they understand the lender's qualification requirements before applying for the loan.
Use our mortgage quote feature to review free, no-obligation quotes from leading lenders. Our quote form is easy-to-use, requires minimal personal information and does not affect your credit. Comparing multiple loan proposals is the best way to save money on your mortgage.
Owner-occupied primary residences and vacation properties are eligible for construction loans. Most lenders do not offer construction programs for investment properties and properties you intend to sell instead of live in require a different type of mortgage. Many lenders also require the property financed to be a detached, single-unit residence.
Related FREEandCLEAR Resources
- Best Fixer Upper Mortgage Programs
- How a Construction to Permanent (C2P) Loan Works
- How to Get a Mortgage on a Fixer Upper
Sources
"Construction Products." Originating & Underwriting. Fannie Mae, 2020. Web.
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