How Construction Loans Work

Construction loans provide funding for you to build a home. Mortgage lenders may have different rules for lending money to construct a new house because the lender must provide money for something that doesn’t exist yet. So, the lenders don't have solid collateral to back the loan. Construction is also a risky process, and lenders don’t like risk.

However, you can secure a construction loan if you meet the lender's qualifications. Learn more about how construction loans work and how you can get the financing that you need to build your dream home.

How Construction Loans Work

If you plan to build your own home, you can explore financing options like construction loans. These loans are also known as a construction-to-permanent loan, a self-build loan, or a construction mortgage.

A construction loan is typically a short-term loan (usually up to one year) that covers the cost of building your home. During the construction phase, the mortgage lender will release the funds gradually as the work progresses. Typically, you will only pay interest on the loan during this time. This keeps payments low, but your payments won't reduce the principal loan balance at this time.

Construction loans generally have variable rates that are higher than traditional mortgage loan rates. Once construction on your house is completed, you can either refinance the construction loan into a permanent mortgage or get a new loan to pay off the construction loan (sometimes called the end loan.)

How to Get a Construction Loan

Applying for a construction loan can be a complex process. You’ll need to prove that your home-building project is real, viable, and relatively low-risk for the lender.

For most construction loan applications, you’ll need to provide the lender with a project timetable and a realistic budget. You’ll also need to supply a comprehensive list of construction details, such as floor plans, the type of building materials to be used, insulation, and ceiling heights, among many others.

Experienced builders typically create an estimate that includes all of these details for a home-building project. If you are working with a builder or willing to teach yourself how to make this document, it can provide a foundation for your loan application.

At a minimum, most lenders require a 20% down payment on a construction loan, and some require as much as 25%. The down payment requirements are generally higher on construction loans because they are viewed as higher risk than a traditional mortgage loan. The lender wants to ensure that you don’t walk away from the project.

Calculate the Size of Your Construction Loan

There are many factors that you should consider when calculating the size of your construction loan. Online construction loan calculators can help you to assess the cost of building your house and to understand the primary expenses.

Be realistic about your budget, and how large of a loan you can afford. Construction project costs can easily overrun, and many house-building projects will come in over budget.

Finance for Buying Land

Buying the land to build your house is likely to be one of the most expensive items in the overall construction cost. However, securing a construction loan is already quite complex, and, if you can, it makes sense to buy land separately from your construction loan.

The best way to do that is to buy the land up front. However, it’s also possible to arrange a separate loan to finance a land purchase. If you buy land rather than an existing house because you want to build from scratch, then you’ll probably need a land loan. And that raises more problems than getting a normal mortgage. For one thing, there’s no home to act as collateral for the land loan.

The terms of a land loan—such as down payment and interest rate—will depend on the intended use of the land, since this is directly linked to the bank’s risk exposure. In this way, getting land loans is always trickier than buying an existing house, since an existing house gives the bank immediate, tangible collateral, whereas a construction project does not.

For most people looking to buy land and build a house, the best way to arrange a loan is to use it to purchase a build-ready lot with the intention to start construction of a primary dwelling right away. Risks include delays or increase costs along the way, but the timetable can still be manageable from the bank’s perspective. The required down payment will typically be about 15% to 25%.

Qualified Builder vs. DIY

To gain approval for a construction loan, you’ll normally need to prove that you have a qualified builder. A qualified builder is usually defined as a licensed general contractor with an established home-building reputation. If you intend to either act as your own general contractor or build the home yourself, you will need to prove that you are not only experienced, but also licensed and insured. Otherwise, you may not be approved for a standard construction loan.

If you want to build your house yourself, you may need to use an owner-builder construction loan (also sometimes known as DIY home build loan). It can be tough to qualify for these types of loans. But if you provide a well-researched construction plan that demonstrates your home-building knowledge and abilities you can increase your chances of getting approved. Consider creating an emergency fund for unexpected expenses.

Frequently Asked Questions (FAQs)

The Bottom Line

While building your own home from the ground up can be a rewarding process, getting a construction loan requires that you meet the lender's criteria. To increase your chances for approval, put together a detailed project plan, get a qualified home builder involved, and save up enough money for a large down payment before you apply.