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Building a home from scratch can be a great opportunity to personalize your new space. But just like buying a house, construction can be an expensive prospect. Luckily, construction loans provide the funds necessary to buy land and pay for the materials and labor that go into building a new house.

That said, there are several types of construction loans to choose from, and the application and approval process is more complex than for a traditional mortgage. We’ll help demystify construction loans by walking you through how they work, available types of financing and what you’ll need to qualify.

What Is a Construction Loan?

A construction loan is short-term financing that can be used to cover the costs associated with building a house, from start to finish. Construction loans may cover the costs of buying land, drafting plans, taking out permits and paying for labor and materials. You also can use a construction loan to access contingency reserves—if your project is more expensive than you planned—or interest reserves, for those who don’t want to make interest payments during construction.

How Do Construction Loans Work?

Construction loans let future homeowners borrow money to purchase materials and pay for labor necessary to build a home. You also can often use this money to purchase the land you’re building on. If you already own the land, you may be able to use the property as collateral for your loan. Because construction loans generally are intended to cover the building process, they’re typically issued for a period of 12 to 18 months. That said, some loans automatically convert into a permanent mortgage once construction is complete.

Unlike traditional mortgages, construction loans aren’t secured by a completed house. For that reason, the application and approval processes for a construction loan also are more complex than for a mortgage. Your lender likely will want to inspect your architectural plans and examine your financial situation before approving you for financing. You will probably also need to provide an estimated construction timeline and budget.

After you’re approved for a construction loan, you won’t receive all of the funds as a lump sum. Instead, the lender will make payments to your builder through a series of draws—or installments—as they complete various stages of construction. In this way, construction loans act as a line of credit. Draws are scheduled based on the construction timeline, and your lender likely will send an inspector to evaluate the status of construction prior to each payment.

In most cases, you’ll only need to repay interest on funds as they are drawn—not on the entire loan amount. Depending on the lender, you also may have the option to convert your construction loan into a mortgage after construction is complete. If this is not an option, you can apply for a mortgage—or end loan—to pay off your construction loan.

Types of Construction Loans

Building a home is not a one-size-fits-all process. To meet the varying needs of future homeowners, there are several types of construction loans available—primarily, construction-to-permanent and construction-only loans. Owner-builders and homeowners performing extensive renovations on an existing house have separate options.

Construction Loans Compared

Construction Loan Rates

Like interest rates for other types of loans, rates on construction loans generally vary based on the borrower’s creditworthiness, the size of the loan and the loan term. What’s more, interest rates for construction loans typically are variable, meaning they adjust over the course of the loan based on an index, like the prime rate.

More specifically, rates usually hover at about one percentage point above standard mortgage rates. You may find construction loan rates between 5% and 6% today. This is because construction loans aren’t secured by a completed home and are therefore riskier than traditional mortgages.

How to Get a Construction Loan

Before you can get the financing necessary to start your construction project, you’ll need to get approved for a loan. This process is typically more rigorous than for mortgages and other loans because the loan won’t be secured—or collateralized—by a home. In addition to imposing traditional borrower standards, lenders also will need to review and approve architectural plans, an estimated construction timeline and a proposed budget.

To be approved for a construction loan, you will need:

• Good to excellent credit. To reduce their risk, lenders require borrowers to have a minimum credit score of 680 to qualify for a construction loan. However, some lenders may require a score of at least 720. If you’re planning to build a house, consider taking some time to improve your credit score before applying for a construction loan.
• Enough income to pay off the loan. In addition to having a strong credit history, you should have enough income to cover payments on your current debts and the new construction loan. To confirm this, your lender will ask for financial statements or other documentation demonstrating your annual income.
• A low debt-to-income ratio. A borrower’s debt-to-income (DTI) ratio is a comparison of all of your monthly debt payments to your gross monthly income. The lower your DTI, the more cash you theoretically have to make construction loan payments each month. To increase the likelihood that borrowers will be able to make payments, lenders typically require a DTI ratio no higher than 45% when issuing construction loans.
• A down payment of at least 20%. Borrowers usually are required to make a down payment of at least 20% when taking out a construction loan. However, many lenders require more—between 25% and 30% of the total construction costs. The requirement varies by lender, but if you make a down payment of less than 20% you may have to pay private mortgage insurance (PMI).
• Project and construction budget approval. Because of the uncertainties involved in building a house, lenders want to see as much detail about the proposed project as possible. Improve your chances of approval by providing documents like a deed (or purchase offer) for the land, complete blueprints and specifications, a detailed line-item budget in the bank’s preferred format, a payment (draw) schedule and a signed construction contract with change order provisions.
• Builder or general contractor approval. Likewise, you’ll need to demonstrate to the lender that your architect and builder are qualified, licensed and insured. This may involve providing copies of the builder’s insurance certificates, resume and proof of financial stability. You also should include a description of each party’s responsibilities, including the architect, general contractor and anyone else involved in the project.

How to Choose a Construction Loan Lender

There’s a lot to consider when choosing a construction loan lender, and it’s easy to get overwhelmed. For that reason, it can be tempting to settle for the first lender you find. You shouldn’t make this decision in haste. Make sure you choose a lender that fits your unique needs by asking these questions:

• What types of construction loans do you offer?
• What interest rates are available? Are they fixed or variable?
• Do you charge closing costs or other fees?
• Can I use the equity I have in my land toward a down payment?
• How do you pay construction draws—as a percentage of completion or based on a set schedule?
• Can the builder request a first draw to pay for materials?
• What happens if there is a delay in building the home or a sudden increase in construction costs?

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