If you’re looking to build or renovate a home, you may consider using a construction loan. A construction loan is a short-term loan designed to finance the cost of building or remodeling your home. These loans typically consist of two parts: an initial “draw” period, when funds are disbursed as needed, and a “repayment” period, during which the borrower must pay off the loan balance in full. We’ll walk you through how construction loans work so you can decide if it’s right for your needs.
What Is a Construction Loan?
A construction loan is a loan that finances the cost of building or remodeling a property. Homeowners and developers can use this type of financing to pay for labor and materials, permitting fees, landscaping, and many other costs associated with constructing a new home or commercial building. Depending on the location, type of property being built or remodeled, and the projected value of the property post-construction, the loan may cover up to 100% of the project’s costs.
Construction loans vs. mortgage loans
The most significant difference between construction loans and conventional mortgage loans is that a construction loan must be paid off at the end of the building project. In contrast, a mortgage loan is typically repaid over a longer period of time. In many cases, borrowers pay off construction loans by refinancing the balance into a long-term fixed-rate mortgage—but this isn’t always the case.
Additionally, lenders often require collateral for a construction loan. This collateral may include assets such as the parcel the borrower is building on, equipment, inventory, or other assets owned by the homeowner or builder.
How Do Construction Loans Work?
Construction loans typically involve two separate types of financing: an initial short-term loan and—once the project is completed—long-term permanent financing.
The initial short-term construction loan covers the cost of getting started on the project. This money helps to fund land purchases, permits, architectural plans, surveys, soil tests, and other necessary expenses before actual construction can begin.
The second loan—permanent financing—is taken out once construction is complete. This type of loan typically comes with a longer repayment term and lower interest rate than the initial short-term loan. The permanent loan also covers the costs of professional inspections, title insurance, and other closing expenses associated with obtaining a mortgage for the property.
In some cases, lenders may offer an all-in-one construction loan that combines both stages of financing into a single package. This format can simplify the financing process and reduce paperwork for borrowers who need immediate access to funds.
Construction loans are often available from local banks and credit unions. However, they are also available through online lenders and brokers that specialize in real estate construction financing.
Types of Construction Loans
Construction loans come in many shapes and sizes, depending on the type of work, the type of property being built or remodeled, specific lender policies, and individual borrower needs. No matter the type of construction loan you choose, it is essential to understand all the terms and conditions before signing any agreements. Be sure to work with a reputable lender who can help guide you through the process and answer any questions you may have.
Common types of construction loans include:
Construction-to-permanent loans are loans that combine the financing of a construction project and the long-term mortgage loan into one package. This type of loan is ideal for borrowers who need immediate access to funds and want to avoid separate applications and paperwork for each financing stage. The loan begins as a short-term construction loan and converts to a permanent loan once the construction is complete.
Construction-only loans are short-term financing solutions specifically designed for the construction of a new home or other property. These loans provide borrowers with the funds they need to cover the costs of materials, labor, and other expenses associated with building a new structure.
Construction-only loans typically have higher interest rates than mortgage loans but can be used to fund projects that don’t qualify for traditional loan products. This type of loan is best suited for those who want to build their own custom home or renovate an existing property without taking out a large mortgage loan.
Renovation loans are tailored to individuals or families who need to finance renovations to an existing property. These loans are typically shorter-term solutions, with repayment terms of one to five years, and provide borrowers with the necessary funds to cover the cost of materials, labor, and other expenses associated with remodeling or renovating a home. Renovation loans can also have higher interest rates than traditional mortgage loans and may require additional collateral, such as a second lien on the property.
Bridge loans are a type of financing used for borrowers who need immediate access to capital but don’t yet qualify for a permanent loan—often because they need to sell another property to qualify for a new loan. In these cases, bridge loans can provide short-term financing, usually between one and two years, to cover the cost of a project until the borrower can secure a more permanent financing solution. These loans can offer flexibility and favorable terms for borrowers who qualify but typically have higher interest rates than traditional mortgage loans.
Owner-builder construction loans
Owner-builder construction loans provide financing to individuals or families who plan on building their own homes. Unlike traditional mortgage loans, these loans do not require the borrower to use a licensed contractor, allowing them to manage and oversee the project themselves. These loans are usually short-term solutions, with repayment terms of one to five years, and typically require the borrower to provide collateral such as a second lien on the property.
End loans are best for developers who have finished building or renovating a property and want to refinance their short-term financing into a longer-term loan. These loans come at the end of a construction project (hence the name). They are used by borrowers to pay off short-term construction financing and repay the balance over time.
What Do Construction Loans Cover?
Construction loans provide financing for the construction of a new home or other real estate property. These loans typically cover a wide range of expenses, including materials, labor, permitting, and additional costs related to inspections or other items connected with construction.
Depending on the loan and the lender, some construction loans may require borrowers to use licensed contractors for specific tasks. Borrowers may also need to provide additional collateral, such as non-retirement savings or a lien on another property.
Construction Loan Requirements
To qualify for a construction loan, borrowers must meet certain eligibility requirements. Generally speaking, these include having good credit and reliable income sources, as well as collateral—typically a first or second lien on the property being built or renovated. Construction loan requirements may vary by lender, but these are the most common:
- Good credit score. This is often the most critical factor for lenders, as a good credit score indicates a borrower’s ability to repay their loan.
- Verifiable income. To qualify for a loan, borrowers must have a reliable income source to make their loan payments.
- Documentation of your financial history. Lenders may also require borrowers to provide proof of their financial history, such as past tax returns and bank statements.
- Proof of assets and liabilities. Most lenders require borrowers to provide collateral, such as a second lien on the property, to secure the loan.
- Plan for the proposed construction project. Borrowers must provide an accurate and detailed plan for the proposed project, including estimated costs and timelines.
- Contractors/subcontractors. Lenders may require the use of licensed contractors and subcontractors for items like plumbing or electrical work.
- Appraisal or survey of the property. In some cases, lenders may require a professional appraisal or survey of the property to ensure its value.
- Insurance on the property to be constructed. Most lenders require some form of insurance coverage for the project’s duration. This may be true for both the property and any contractors performing work on the project.
- Signed agreement. A signed agreement between the lender and borrower is required, outlining the terms of the loan. This document must typically be between all parties involved in the loan application process.
How to Get a Construction Loan
Getting a construction loan is a bit more involved than a conventional mortgage. Here are the steps to get a loan to finance building or renovating a property:
- Gather documents: Before you apply for a construction loan, make sure that you have all the necessary documents in hand. These include proof of your income and assets, details of any collateral, an accurate and detailed plan of the proposed construction project (including estimated costs and timelines), documentation of your financial history (such as past tax returns and bank statements), an appraisal or survey of the property, proof of insurance, and a signed agreement between all parties involved in the loan application process.
- Check your credit score: Most lenders require applicants to have a good credit score to qualify for a construction loan, so check your credit score before applying. This can help you evaluate whether you are likely to be approved and can help you know what interest rates you may be eligible for.
- Research lenders: Once you have prepared all the necessary documents and checked your credit score, research different lenders that offer construction loans. Make sure you compare interest rates, repayment terms, fees, requirements, and other factors before deciding which lender to use.
- Submit your application: After researching different lenders, choose one that best fits your needs and submit an application with all required documents attached. Make sure that all information is accurate and up-to-date to prevent delays in processing your application.
- Await approval: When you’ve submitted your application, you’ll need to wait for lender approval. This process typically takes 10 to 14 days, but it can take longer, depending on the lender’s policies and procedures. It may also require submitting additional supporting documents or answering the lender’s questions about the project.
- Receive your first draw: Once your loan is approved, your lender will begin disbursing funds according to the terms agreed upon in the contract. Funds may be disbursed as needed during construction or when certain milestones are achieved throughout the building process.
- Make repayments on time: When your construction project is complete and all loan funds have been disbursed by the lender, you’ll enter the repayment period of your loan. Once you do, make timely repayments based on your repayment schedule. This helps build good credit history and avoid incurring late fees, penalties, or foreclosure on your collateral.
What to consider when getting a construction loan
Before applying for a construction loan, it is important to consider the following:
- Your financial situation. You should have a good understanding of your finances, including income and assets. This will help you assess whether you can afford the loan and how much you are able to borrow.
- Interest rates and repayment terms. Be sure to compare different lenders to find the best interest rates and repayment terms that suit your needs.
- Insurance coverage. Check to make sure you have adequate insurance coverage for any risks associated with the project. This will help protect both you and the lender in case of an accident or damage to the property during construction.
- Documentation. Gather all relevant documents for your loan application and check that they’re accurate and up-to-date, as mistakes could lead to delays in the application process.
- Credit score. A good credit score is usually required for approval on a construction loan. Checking your credit score before applying can help you determine if you are likely to be approved and what interest rate you may be eligible for.
Construction loans are a great option for those who want to build or remodel a property without using their own cash to cover expenses. Borrowers can enjoy the convenience of a single loan solution by obtaining an initial short-term loan to cover the costs of getting started and then refinancing with permanent financing once the project is complete. While construction loans may require more paperwork than traditional mortgages, they’re often worth it for those seeking flexibility in financing their dream home or commercial building.