Construction Loans: What They Are and How They Work

Finding the right house can be a challenging endeavor, and some buyers may decide to build their own home instead. However, financing this type of project is often complex — that’s where construction loans come in. These loans provide the funds needed to build your home, from start to finish.

Exploring what construction loans are, the different types available and how to get one will help you decide if this financing suits your needs.

Key Takeaways

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A construction loan is short-term financing for covering the costs of building or renovating a home, typically issued for a year or less.

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Construction loans come in different types, including construction-to-permanent loans, construction-only loans, renovation loans, owner-builder loans and end loans.

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Construction loan rates are typically higher than traditional mortgages and are often variable, depending on the borrower’s credit and the loan terms.

What Is a Construction Loan?

A construction loan is short-term financing used to cover the costs associated with building or rehabilitating a house. Unlike a mortgage, which provides long-term funding for a completed home, a construction loan is considered specialty financing because it is only used during the building process.

Construction loans typically cover the following costs:

  • Buying the land or lot
  • Paying for contractor labor and building materials
  • Taking out permits

It’s worth noting, however, that construction loans don’t include design costs, such as architectural fees or interior planning. These must be managed separately from the loan.

How Construction Loans Works

Construction loans are short-term loans, usually lasting for one year or less, to cover the costs of building or renovating a house. The application process involves submitting detailed plans for the project, including cost estimates, timelines and the credentials of your contractor or builder. Lenders carefully review these details because construction loans carry more risk than traditional mortgages.

Once approved, construction loans disburse funds in stages, referred to as "draws." These occur at specific milestones in the construction process, such as when the foundation, framing or roofing are completed. Your lender typically requires inspections at each stage to ensure the project is progressing as planned. Interest is usually charged only on the amount disbursed, and during the construction phase, payments are often interest-only.

When construction is complete, you have options for handling the loan. You can refinance the construction loan into a permanent mortgage or take out a new loan to pay off the balance. Some construction loans automatically convert to a traditional mortgage, simplifying the transition to long-term financing.

Types of Construction Loans

Construction loans come in different types, offering flexibility depending on whether you're building a new home, renovating an existing one or handling the construction yourself. Understanding these types can help you choose the best option for your project.

Construction-to-Permanent Loan

A construction-to-permanent loan covers both the building phase and your long-term mortgage. Initially, it functions as a construction loan, providing funds during the construction process. Once construction is complete, the loan automatically converts into a permanent mortgage, eliminating the need for refinancing.

This option is convenient for borrowers who want to simplify their financing and avoid closing multiple loans. Payments during construction are usually interest-only, based on the disbursed amount.

Construction-Only Loan

A construction-only loan provides funding solely for the building phase. It does not convert into a mortgage once construction is complete, meaning you must refinance or take out a separate loan to pay off the balance. These loans may be appealing for borrowers who want flexibility in choosing a permanent mortgage after construction. However, they require you to go through two separate loan closings, which can involve additional costs and paperwork.

Renovation Loan

A renovation loan finances the rehabilitation or remodeling of an existing home. These loans are ideal for homeowners who need to upgrade their current property rather than build a new one. The loan amount is typically based on the future appraised value of the home after renovations are complete.

Renovation loans can cover repairs, expansions or aesthetic updates and are often integrated into a permanent mortgage, allowing borrowers to spread payments over time. Here are some low-down-payment renovation mortgage programs worth considering:

  • HomeStyle Loans: Backed by Fannie Mae, HomeStyle loans allow borrowers to finance home renovations with as little as 3% down. These loans are available for primary residences, second homes and investment properties.

  • CHOICERenovation Loans: Freddie Mac's CHOICERenovation loans offer flexible renovation financing with as little as 3% down. They allow borrowers to use funds for disaster-proofing renovations and cover both cosmetic and structural improvements.

  • FHA 203(k) Loans: The FHA 203(k) loan program lets borrowers finance renovations with a down payment as low as 3.5%. This program is specifically designed for purchasing and renovating primary residences.

  • USDA Renovation Loans: USDA renovation loans provide 100% financing for home improvements in eligible rural areas. These loans are aimed at low- to moderate-income borrowers and can cover both purchase and renovation costs.

Owner-Builder Loan

An owner-builder loan is designed for individuals who plan to act as their own general contractor for the construction project. These loans require borrowers to have significant experience in construction or home building because lenders take on more risk when the borrower manages the construction themselves.

This type of loan provides flexibility for those who want to oversee every aspect of their home’s construction, but the approval process can be more rigorous than that of other construction loans.

End Loan

An end loan is a traditional mortgage that takes effect after the construction phase is complete. This loan differs from construction loans because it provides long-term financing only after the construction is finalized.

Typically, borrowers use a separate construction loan to finance the building process and then transition to an end loan, which covers the permanent financing for the home. This option requires two separate loan closings and can lead to additional closing costs.

Construction Loan Rates

Construction loan rates vary based on factors like the borrower’s creditworthiness, loan size and loan term. Typically, these loans come with variable interest rates, which means the rate can fluctuate over the course of the loan. This can lead to changing monthly payments during the construction phase.

Because construction loans are unsecured, meaning there’s no existing property as collateral during the build, interest rates tend to be higher than the current rates for traditional mortgages. Lenders charge more to offset the added risk of financing an incomplete property.

Construction Loan Requirements

Eligibility for construction loans requires meeting specific criteria that demonstrate your ability to complete the project and repay the loan. Lenders look at several factors to determine your qualification for this type of financing, including:

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    Credit Score

    A good credit score is essential for securing a construction loan. Lenders typically prefer a score of 680 or higher, though some may consider lower scores with stricter terms. A strong credit score shows you’re reliable in managing debt, which reduces the lender’s risk.

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    Debt-to-Income Ratio

    Lenders assess your debt-to-income (DTI) ratio to ensure you have enough income to cover the loan payments. A DTI below 45% is usually required, though lower ratios are preferred. This ratio helps lenders evaluate whether you can manage your current debts along with the construction loan.

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    Down Payment

    A larger down payment is usually required for construction loans, often around 20% of the total project cost. This is because lenders take on more risk when financing a home that hasn’t been built yet. A higher down payment reduces their exposure to potential losses.

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    Choice of Builder

    Lenders require you to choose a licensed and experienced builder for the construction project. The builder must provide credentials and a history of completed projects. This ensures that the construction will be completed by a professional capable of managing the project efficiently.

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    Construction Plan

    A detailed construction plan is necessary for approval. This plan should include cost estimates, timelines and project details. Lenders use the plan to determine the loan amount needed and assess whether the project is feasible and within budget.

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MONEYGEEK EXPERT TIP

The loan-to-value (LTV) ratio is a key factor that lenders consider when approving construction loans. It’s calculated by dividing the loan amount by the property's appraised value. For construction loans, lenders typically prefer an LTV ratio of 80% or lower, meaning you’ll need at least a 20% down payment.

A lower LTV ratio reduces the lender’s risk and can lead to better loan terms, such as a lower interest rate. — Alvin Yam, CFP

How to Get a Construction Loan

Securing a construction loan involves several steps that ensure you are prepared to finance and manage your home-building project. Following a clear process will help you meet lender requirements and make the loan approval smoother.

1
Find a Licensed Builder

Select a licensed and reputable builder with experience in similar construction projects. Lenders typically require the builder to be certified and have a history of successfully completed projects. Make sure your builder provides credentials and references to strengthen your loan application.

2
Choose a Construction Loan Lender

Research and select a lender that offers construction loans with favorable terms. Make sure the lender also has experience in handling construction financing, as they will guide you through the specialized process. Compare interest rates, fees and loan conditions to find the best fit for your project.

3
Gather Required Paperwork

Prepare the necessary documents, including your financial information, detailed construction plans, builder contracts and cost estimates. This paperwork helps the lender assess the project’s feasibility and your ability to repay the loan. Providing accurate and thorough documentation speeds up the approval process.

4
Get Pre-Approved

Submit your paperwork to get pre-approved for a construction loan. Pre-approval gives you a better idea of how much you can borrow and ensures you're financially ready to begin the project. It also shows builders and contractors that you are serious about moving forward.

5
Purchase Homeowners Insurance

Before closing on the loan, purchase homeowners insurance that includes coverage for the construction phase. Lenders often require this insurance to protect against potential risks during the building process. It also ensures that your property will be covered once construction is complete.

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HOW TO GET A CONSTRUCTION LOAN WITH NO MONEY DOWN

Getting a construction loan with no money down is challenging but possible through certain loan programs. One option is a USDA construction loan, which offers 100% financing for eligible borrowers in rural areas. You must meet income limits and property location requirements to qualify.

Another option is a VA construction loan, which provides no-down-payment financing for veterans and active-duty military members. To qualify, you need a Certificate of Eligibility and meet the lender's credit and income standards.

FAQ About Construction Loans

We answered some frequently asked questions about construction loans to help you decide if this option is right for your particular needs.

Is it hard to qualify for a construction loan?
How do construction loans differ from traditional mortgages?
How are funds disbursed in a construction loan?
Are interest rates on construction loans higher than traditional mortgages?
Can I get a construction loan if I want to build the house myself?
Can I use a construction loan to renovate an existing home?
How do I transition from a construction loan to a permanent mortgage?
What happens if the construction project takes longer than expected?

About Zachary Romeo, CBCA


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Zachary Romeo is a certified Commercial Banking and Credit Analyst (CBCA), and the Head of Loans and Banking at MoneyGeek. Previously, he led production teams for some of the largest online informational resources in higher education, with over 13 years of experience in editorial production.

Romeo has a bachelor's degree in biological engineering from Cornell University. He geeks out on minimizing personal debt and helping others do the same through people-first content.


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The content on this page is accurate as of the posting/last updated date; however, some of the rates mentioned may have changed. We recommend visiting the lender's website for the most up-to-date information available.

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