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Construction Loans: What Are They, And How Do They Work?

5-Minute Read
Published on March 4, 2020

If you’ve been going from open house to open house not finding anything you like, you might be beginning to fantasize about giving up on the home search and just building the exact house you want.

While building a new home can be expensive, it’s not completely out of reach, especially if you get a loan to finance the process.

What Is A Construction Loan?

A home construction loan is used to cover the costs of building a home. Once the funds from the construction loan have been used and the house has been built, these loans are typically converted or refinanced into a standard, long-term mortgage loan.

If you want to build a brand-new house from the ground up but don’t have the funds to do so out of pocket, a construction loan will likely be your best option.

These are short-term loans – funds are typically available for a year or so while construction is completed. After that, the loan will need to be converted into a mortgage loan or paid off by other means.  

How Do Construction Loans Work?

Before you can get a construction loan, you need a plan. A plan for your future house, that is.

To be approved for a construction loan, not only will you have to go through the typical process of proving your creditworthiness and ability to repay the loan, you’ll also have to show the lender detailed plans for the project, including cost estimates. The lender may also need to approve of the company that’s building your home.

You won’t be approved for a construction loan until you have all these details sorted out. However, you may want to start having conversations with potential lenders before you begin the planning process, so you can get a better idea of how much you’ll likely be able to borrow.

Once you’ve got your plan and your loan approval, and you’re preparing to break ground, your builder will receive the first disbursement of the funds.

With construction loans, the money isn’t given to you in one large, lump sum. Instead, the builder receives a series of disbursements called “draws.” Whenever your builder requests a new draw for the next stage of work, an inspector will come to the site and check out the progress on behalf of the lender.

Before you break ground, be sure both you and your builder understand the lender’s draw schedule, including when and how disbursements are made.

During building, you can typically make interest-only payments on the loan, and you’ll only be charged interest on the amount that’s been disbursed.

Types Of Construction Loans

As you shop around for loans, you’ll need to decide which type makes the most sense for you. When it comes to construction loans, there are a few different kinds available, each with their own pros, cons and requirements. Let’s take a look.

Construction-To-Permanent Loan

A construction-to-permanent loan is a construction loan that converts to a permanent mortgage once building is completed.

With this type of loan, all your financing is rolled into a single transaction, meaning you’ll only have to complete one application and go through one closing process. This can make financing your home simpler and potentially cheaper, as you’ll only be paying closing costs on one loan.

Additionally, with a construction-to-permanent loan, you don’t have to worry about not being able to obtain financing for a mortgage once your home is completed. Once you have your approval for the loan, you won’t need to go through the approval process again; the loan will simply convert into a permanent loan when construction is completed.

Construction-Only Loan

A construction-only loan is exactly what it sounds like: you’re receiving the funds to cover only the cost of construction. After that, you’ll need to get another, separate loan to refinance the construction loan into a mortgage.

With these types of loans, you’ll go through two separate application processes and two separate closings. This can mean extra documentation and paperwork, and possibly more money spent on overall closing costs.

Why would someone want a construction-only loan? The main benefit of these types of construction loans is that they give you the freedom to shop around for your mortgage. When you get a construction-to-permanent loan, you’re limited to whatever rates and terms are offered by the construction loan lender. Construction-only loans allow you to find the mortgage that is best for you.

Renovation Loan

If, instead of building a whole, brand-new house, you want to buy a fixer-upper home to renovate and rehab, there are loans that allow you to do that.

A 203(k) loan is one such type of loan. These are insured by the FHA and give home buyers the funds to purchase a home plus money to complete needed renovations. Rocket Mortgage® does not offer 203(k) loans. Conventional loan borrowers also have options for these types of loans with Fannie Mae’s HomeStyle® Renovation Mortgage and Freddie Mac’s CHOICERenovation℠ Mortgage.

Homeowners who want to fix up the home they currently live in can also refinance into one of these renovation mortgages, giving them the funds to renovate their current home.

If you don’t need a whole mortgage but just enough cash to pay for repairs or renovations, you may consider tapping into your equity with a home equity loan, home equity line of credit or cash-out refinance. Rocket Mortgage® does not offer home equity loans or home equity lines of credit but does offer cash-out refinances.

Owner-Builder Construction Loan

Owner-builder construction loans are aimed at individuals who wish to be their own general contractor instead of hiring a builder to manage the process and all the different subcontractors involved. While acting as your own general contractor can save money, this option is typically only available to those who have proven experience as a home builder or are licensed to oversee these types of projects.

What Do Construction Loans Cover?

Generally, construction loans won’t be paid to the borrower; instead, the funds go directly to the builder or general contractor as needed. These funds can be used for all the costs related to the project, including permit costs, materials, labor and other expenses.

Construction loan funds can only be used for the building of your home. Don’t expect to be able to use any leftover money to furnish your new house.

Construction Loan Rates And Requirements

The rate you’ll get on a construction loan will depend in part on the type of loan you get. Construction-to-permanent loan rates are typically more in line with standard mortgage rates, while construction-only loan rates might be slightly higher.

You’ll go through the same typical documentation process you would with a regular mortgage; you’ll be asked to provide things like tax returns, W-2s, bank statements and other documents proving your ability to afford the loan.

A 20% down payment is typical for construction loans. Conventional mortgage lenders typically like to see a credit score of at least 620 and a debt-to-income ratio below 45%, but individual construction loan lenders may have more stringent requirements.

The construction loan lender may also require that you have a certain amount of cash set aside in case building costs end up being higher than expected.

What Is An End Loan?

An end loan is a regular mortgage; it’s just another name for the mortgage loan that you’ll use to pay off your construction loan.

While Rocket Mortgage® doesn’t offer construction loans, we can help refinance construction loans into regular mortgages through Rocket Mortgage®.

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Andrew Dehan

Andrew Dehan is a professional writer who writes about real estate and homeownership. He is also a published poet, musician and nature-lover. He lives in metro Detroit with his wife, daughter and dogs.