What Is a Construction Loan, and How Does It Work?
By Tim Bakke | Updated June 08, 2023
Getting the Most Out of Your Building Loan
Construction home loans are essentially mortgages for people who are building their own home (or doing major renovations!) instead of purchasing an existing home. Because of this, they have a bit of a different structure and requirements than a typical mortgage, which we will explain below.
Types of Construction Loans
There are two main types of construction loans to choose from — each with different benefits depending on your needs.
Construction-Permanent Mortgage
This is a combination loan that merges your construction loan and home’s mortgage into one package. The main benefit of choosing a construction-permanent mortgage is that there is only one closing for both loans — which can save you time and money.
Another benefit is that the interest rate for this loan is guaranteed up-front and won’t be subject to any changes over the many months you build your home. This makes planning ahead and budgeting a bit easier in the long run.
Construction-Only Mortgage
A construction-only mortgage splits the construction loan and home’s mortgage into two separate loans. This mortgage only provides short-term financing for the construction period. When your home is complete, you would then go through the process of taking out your home’s mortgage and going through another closing.
The real benefit of doing things this way is that your initial monthly payments would be lower because you are only paying interest on the smaller loan rather than your entire home’s value. However, because of this, the deposit needed for this type of loan could be higher than a construction-permanent mortgage.
There are also two less common types of construction loans, as explained below:
Owner-Builder Loan
In this type of loan, the lender disburses money to the owner-builder instead of a third-party contractor. This loan is great for owners who want to act as their own general contractor, but it’s worth noting that you usually need to have built homes before or hold a contractor’s license to be approved.
Renovation Loan
This is very similar to a typical mortgage; however, instead of being based on a home’s value at purchase, it is based on the appraised value of a home after the renovations are complete. A great option if you intend to purchase a fixer-upper.
How Do Construction Loans Work?
If you plan on taking out a type of construction loan, we let you know what you need to know below.
How Do I Get Started?
The approval for a construction loan is different from applying for a standard mortgage on an existing home. Once you decide to build your own home rather than purchasing an existing one, there are a few steps you need to take.
The first step is to choose your builder and finalize your house plans.
If that sounds a bit daunting, here are the resources to assist:
Once you’ve made those big decisions, you’ll have the required paperwork to proceed with your construction loan application.
It’s important to remember that you will be subject to the normal requirements for getting a mortgage (like proof of your income, expenses, financial history, etc.), plus the following extras:
- house plans
- permits from local government
- fixed-price building contract
- applicable insurance (such as public liability insurance and builder’s all-risk insurance)
In addition to these items, it’s normal for a property appraiser to estimate the value of the home once finished on behalf of the lender. They might also update this throughout the building processes as they continue to evaluate the property.
What Happens When My Loan Is Approved?
Congratulations! You’ve gathered the required paperwork and are now approved for the construction loan of your choice.
The next step is to make a deposit with your lender.
Construction Loan Financial Responsibilities
As with a home mortgage, you will be responsible for coming up with a down payment; you’ll also be responsible for making increasing interest payments as you incur more debt during construction.
What Is the Down Payment on a Construction Loan?
The size of your down payment depends on your particular mortgage lender. However, much like with a traditional mortgage, a deposit of at least 20% of the total cost is recommended to avoid the need for Private Mortgage Insurance (PMI).
If your down payment is less than 20% of the total cost (that is, the price of both the land and construction costs combined), you will need PMI in most cases as well as a minimum deposit of your own funds (not a gift!) of 5%.
What Will My Monthly Construction Loan Payments Be Like?
It doesn’t matter if you chose a construction-only or a construction-permanent mortgage. While building your home, most lenders ensure that you will only pay interest on your loan each month. Most lenders will not require you to enter principal repayment during the construction phase; however, be sure to double-check your lender’s standard practice.
What Is Progressive Drawdown?
The reason for the commonality of this practice is that you might not use all of the money from the loan, so you only need to pay interest on the funds you actually withdraw and put towards construction. This process of releasing the money in stages rather than all at once is known as “progressive drawdown.”
Thus, your monthly payment will vary depending on the full total that you or your builder borrows against your loan. Because of this, as you near the end of the construction period and you use more money, the payments will gradually increase. As you continue to draw funds against the loan, your lender might require paperwork from the builder to confirm that work is finished.
A timeline of progressive drawdown might look something like this:
- Foundation construction
- Framing stage
- Walls, Windows, Doors
- Fixout (Utilities)
- Completion
When the home is fully built, you will begin to repay both principal and interest on the loan.
What Happens if I Make Changes to My Home During Construction?
Changes to the original house plan happen all the time during home construction. If you decide you want to make a change that could alter the value of the home, you should typically speak to your lender before proceeding with those changes.
They could be things like increasing or decreasing the home’s square footage or adding or subtracting the number of stories.
Smaller changes and tweaks might not need to be approved by your lender, but it’s always best to check what their specific policy is before proceeding.
However, it is essential to note that unless you have made provisions for potential overages in your original loan, you will need to pay cash for these expenses upon construction’s completion.
Do I Need a Construction Loan for the Entire Process?
Yes! A lender will typically not finance a half-built house. Everything included as a part of your application plans and specifications needs to be present in the final build. That is, if you told your lender you were going to build it (and they gave you money to build it!), then you need to build it. You can’t use the loan up and then save finishing the work for later.
Additionally, it’s very tricky to get a construction loan on an already under-construction home. Even if you think you will be able to build your house with cash, it’s a good idea to chat with a construction loan representative and your contractor to get an accurate picture of the project’s costs.
You can also use our Cost to Build Estimator Tool is a good starting point in these conversations.
How to Choose a Construction Loan Lender
Choosing a construction loan lender is much like choosing the financier for any other traditionally large purchase. An excellent place to start is by checking out our helpful guide to home financing here, but here are two of the most valuable bits:
Shop around for Your Loan
Most banks offer loans but not choices. One way to get different options is to go shopping at each bank in town. This takes time but usually is worth the effort. Call your local banks and ask for the construction loan department or a construction loan officer. Ask friends and family about their banking loan experiences.
Ensure the Construction Lender is Experienced
As construction loans differ from conventional home mortgages, you’ll find the process much smoother if you work with a lender who has a history of providing construction loans for residential home construction.
Using a construction loan to build your dream home can be a straightforward process, especially if you use one of our plans. If you have any questions about construction loans and our plans, please don’t hesitate to be in touch.
Footnote: The lead image of this article is a photo by Josh Olalde on Unsplash.
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