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What are construction loans?
Construction loans are loans that fund the building of a residential home (aka a stick-built house), from the land purchase to the finished structure. Common types are a standalone construction loan — a short-term loan (generally with a year-long term) — which only finances the building phase, and a construction-to-permanent loan, which converts into a mortgage once the construction is done. Borrowers who take out a standalone construction loan often get a separate mortgage to pay it off when the principal falls due.
TYPES OF CONSTRUCTION LOANS
Construction-to-permanent loan
With a construction-to-permanent loan, once the house is complete and you move in, the loan morphs into a traditional mortgage. Typically, you can choose your term of 15 to 30 years, and you can opt for a fixed rate or an adjustable rate. During the construction-loan phase, you’re only responsible for interest payments on the money drawn, as it’s drawn. After the conversion, you start making payments that cover interest and the principal — as you would with a typical mortgage.
Construction-only loan
A construction-only loan provides the funds necessary to build the home, but the borrower is responsible for repaying the loan in full at maturity (typically one year). You can settle the debt in cash, by obtaining a mortgage, or extending the construction loan another 6 months to a year.
Renovation loan
If you want to upgrade an existing home rather than build one, you can compare home renovation loan options. These come in a variety of forms depending on the amount of money you’re spending on the project.
End loan
An end loan simply refers to the homeowner’s mortgage once the property is built.
What Costs are covered by a construction loan?
You can use a construction loan to cover such costs as:
The land/lot
Contractor labor
Building materials
Permits
As the name implies, construction loans cover the costs of building a home.
Typically, that means the expenses associated with construction, such as contractor fees, labor and permits.
But you can also use the funds to purchase the land or property lot itself.
However, construction loans do not include design costs. If you want to hire a professional architect or interior designer, you’ll need to cover that cost on your own.
CONSTRUCTION LOANS VS. TRADITIONAL MORTGAGES
Beyond the cost and repayment timeline, construction loans and mortgages have a few main differences:
THE FUNDS DISTRIBUTION
Unlike mortgages and home equity loans, which provide funds in a lump-sum payment, the lender pays out the money for a construction loan in stages as work on the new home progresses. These draws tend to happen when major milestones are completed — for example, when the foundation is laid or the framing of the house begins.
THE REPAYMENTS
With a mortgage, you start paying back the principal and interest right away. With construction loans, your lender will typically expect you just to make interest payments during the construction stage. Additionally, borrowers are only obligated to repay interest on actual funds drawn to date until construction is completed.
INSPECTION/APPRAISER INVOLVEMENT
While the home is being built, the lender has an appraiser or inspector check the house during the various construction stages. As the work is approved, the lender makes additional payments to the contractor, known as draws. Expect to have between four and six inspections to monitor the progress.
REQUIREMENTS
As with mortgages, construction loan borrowers need to be financially stable and able to make a down payment. But since there’s no property to appraise, lenders also want to see a construction plan, a detailed outline of the project, in deciding how much to give you.
INTEREST RATES
Construction loan interest rates are typically higher than traditional mortgage rates. The reason: There’s no existing structure to provide collateral to back the loan. That means the lender is taking on more risk.