6 min read Jul 06, 2024

Construction Loans 101: Everything You Need to Know to Get Started

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Edited By

Megha Mulchandani

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Editor
Edited By

Megha Mulchandani

Editor, Houzeo
About

Megha M. is an adept content editor well-versed in the intricacies of American market dynamics and economic trends. In her free time, she excels as a versatile theatre artist and public speaker.

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In the pursuit of the perfect home, many of us end up compromising convenience for the character. While ready-to-move-in homes offer immediate comfort, they often lack the unique touch of a personalized space. 

Moreover, the steep prices attached to pre-built properties can be a huge deterrent. Consider this: In 2024, NAHB found that 76.9% of U.S. households couldn’t afford the median-priced new home at $495,750. But fear not, for there’s a solution that empowers dreamers to craft their ideal abode-construction loans.

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What Is A Construction Loan?

A construction loan is a small-term loan with the single-use purpose of constructing a home. 

A construction loan significantly cuts costs via the elimination of intermediaries, direct payments to constructors, and reduced installments. However, a significant drawback remains- a construction loan is to be repaid by the end of the loan term (usually 12 months).

What Are The Types Of Construction Loans?

One type of construction loan cannot suit everyone’s diverse needs. Some may need a loan solely to construct their dream home. Others may require it to purchase land and then construct. Additionally, some people need loans for major renovations. 

Therefore, a single loan type cannot accommodate varied requirements.  

Construction-to-Permanent Loan

Despite being a short-term loan, construction loan amounts are usually substantial and hard to repay quickly.

The perfect solution for this problem is taking a construction-to-permanent loan. Instead of full repayment at term, construction loans convert to 15-20-year traditional mortgages.

Construction-Only Loan

A construction-only loan, unlike a construction-to-permanent loan, requires full repayment at the term’s end. Borrowers may pay in cash if the amount is small or take a long-term loan for larger sums 

Renovation Loan

A renovation loan is for owners who want to undertake major renovations on their property. Although there’s no specific benchmark, renovation work is typically time-consuming and costly.

Owner-builder Construction Loan

An owner-builder construction loan is rare because the bank must recognize the owner as a qualified constructor. Given the complexities of construction, only certified owners typically qualify for these loans.

End Loan

An end loan resembles a construction-to-permanent loan but involves a new loan after the closure of the construction loan. This results in two separate loans with different closures. 

How Do Construction Loans Work?

Despite common belief, financing new home construction costs less than purchasing an already-built home. Fewer fees and markups, without intermediaries, resulting in savings in the total construction cost. 

To better understand this, let’s explore how a construction loan works: 

Securing a Construction Loan

Due to its short-term nature, a construction loan cannot be acquired as a single lump sum. Instead, the borrower must provide the lender with a contractor-approved construction plan blueprint. 

This plan must outline various milestones that would need financial support. The lender disburses funds incrementally, assessing construction progress continuously. 

Typically, four to six payouts are released over a 12-month loan term.

Construction Loan Repayment

Unlike the loan disbursement, repayment must be in one lump sum installment. Since no principal is repaid during construction, the entire amount is due by the end of the loan tenure. 

Generally, borrowers convert the construction loan into a traditional mortgage at the end of the tenure. 

Installments Repayment

During the loan term, borrowers pay interest only on disbursed amounts, not the entire loan. This reduces monthly installments, easing financial management and lowering default risks.

How Do Construction Loans and Traditional Mortgages Compare?

Construction loans and traditional mortgages differ significantly in their features: 

Time Frame

The time frames of a construction loan and a traditional mortgage differ significantly. A construction loan is a short-term loan that lasts over 12 months, whereas a traditional mortgage is generally a long-term loan that can sometimes last as long as 20 years.

Collateral

As a construction loan is a short-term loan, it is mostly free of collateral. However, this is not the case with traditional mortgages, whose name suggests the involvement of collaterals.

Interest Rates

While there’s no set standard, construction loan rates generally tend to be slightly higher than traditional mortgage rates.

Loan Disbursal

Traditional mortgages provide borrowers with lump sums for unrestricted use. In contrast, construction loans are disbursed in four to six installments directly to the contractor, ensuring funds are solely used for construction.

How Do I Get A Construction Loan?

Receiving construction financing is almost similar to getting a traditional mortgage, there are two additional steps to be followed:

Get a Certified Constructor

To secure a construction loan, hire a certified constructor with experience. The loan amount is disbursed directly to the constructor, ensuring funds are dedicated solely to construction. This minimizes misuse risk, keeping projects on budget.

Draw an Extensive Construction Plan

Then, create a detailed construction plan with the constructor’s input. Submit it to the bank for approval. The bank uses this plan to schedule the contrition appraisals and the loan payouts. As the payouts depend on it, ensure the plan is as extensive as possible. 

What are the Rates for Construction Loans?

Construction loan rates fluctuate based on market conditions and policies. Typically, they’re higher than traditional mortgage rates. This is because of the lack of collateral and shorter duration. On average, construction loan rates are 1% higher than traditional mortgages. 

Bottom Line

Construction loans offer a personalized approach for custom homes. They also provide options for financing land purchases. If you own the land, a construction loan is ideal. With controlled spending and manageable installments, they offer savings, fulfilling your dream home without extra costs.

Borrowers select from various types of construction loans based on their needs and finances. However, downsides exist. 

Unlike traditional mortgages, construction loans have fixed purposes and less flexibility. Additionally, the full amount is due at the loan term’s end, usually 12 months. Hence, we advise thoroughly examining finances and the loan’s implications on your bank account before signing loan documents. 

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Frequently Asked Questions

How Much of a Loan Can I Get for Construction?

The amount you can get for a construction loan typically depends on factors like your creditworthiness, the cost of the project, and the lender's policies, often up to 80-85% of the total project cost.

What Is the Credit Score for a Construction Loan?

A good credit score for a construction loan is around 680 or higher, though requirements can vary by lender and specific loan terms.

How to Draw Money From a Construction Loan?

Money from a construction loan is drawn in installments based on the project's progress, following a pre-approved schedule and meeting construction milestones as verified by the lender.

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