Basics of Construction Loans
Mortgages are easy to find, but there’s usually a catch: you can only borrow money to buy a place that already exists. But construction loans are different, and they'll fund a new home, garage, or business structure. They can even help you renovate and buy land (if you don't already have it).
Construction loans are less popular than standard home loans, but they are available from numerous lenders.
If you’re thinking of building, this page describes the basics of these loans. However, every lender handles things differently, so the details will depend on who you work with.
Basics of a Construction Loan
A construction loan is a short term loan for real estate. You can use the loan to buy land, you can build on property that you already own, and with some programs you can even renovate existing structures. These loans are similar to a line of credit: you only borrow what you need when you need it, and you only pay interest on the amount borrowed (as opposed to a standard loan, where you take 100% of the money available up front and start paying interest on the entire balance immediately).
During the construction phase, you’ll generally make interest-only payments (or no payments at all in some cases) based on the amount you’ve borrowed to-date. As certain milestones are reached, you or your builder will request draw payments for work that has been completed.
An inspector will verify that the work was done (but will not evaluate the quality of work), and a disbursement will go to the builder if all is well.
Loans typically last less than one year, and they are repaid with another "permanent" loan – you’ll get rid of the construction loan once construction is complete.
Since construction loans have higher (often variable) rates than traditional home loans, you don’t want to keep the loan forever anyway. To retire the loan, you’ll get an appraisal and inspection on the completed property and refinance into a more suitable loan.
There are two ways to get rid of the temporary loan:
- Apply for a new loan after building is completed, or
- Arrange both loans up front (also known as single-closing )
Funds from a construction loan can be used for just about any portion of your project: buying the land, digging a hole, pouring foundation, framing, and finishing. You can also build garages, basic sheds, and other structures, depending on your lender’s policies.
As with most loans, don’t count on borrowing 100% of what you need. Most lenders require that you put some sort of equity into the deal. You can of course bring money to the table, but if you already own land you can use the property as collateral instead of cash.
A Solid Plan
To get a construction loan, you’ll need to qualify, just like with any other loan. That means you need good credit and favorable ratios (debt to income and loan to value). Consistent income also helps.
Construction loans are unique because the bank needs to approve your construction plans.
If you’re buying from a builder that regularly works with a particular lender, approvals might be streamlined. However, more "custom" projects can be challenging. Expect your lender to ask for complete details about the project: who is doing the work, how exactly will it be done (architectural drawings will help), what’s the schedule, what are the projected costs, will the structure meet local codes and requirements, and how much will the property be worth at completion? Unfortunately, you can’t just wing it.
What if you want to do all of the building work yourself? That makes things even more difficult. Banks are hesitant to work with owner-builders – they’re afraid there’s a better chance that the project will head off-course. Unless you’re a full-time professional contractor with years of experience, you’ll probably have to hire somebody else.
Having a plan is great, and having flexibility is even better. Construction projects are notorious for delays and surprises, so be sure to leave some wiggle room. Don’t plan to spend everything the bank is willing to give you, and don’t plan on moving out of your existing home the day after "projected" completion.