With the low inventory of existing homes up for sale and sky-high mortgage rates, building a new house is becoming more attractive to buyers. Some builders are sweetening the pot by offering incentives and deals for new-construction properties.
The best part is you don’t need all the cash on hand to pay for land, labor and materials.
Construction loans are available for individual borrowers to help finance projects from start to finish, and they aren’t just for brand-new homes, either. Construction loans can also cover the costs of renovating older homes in need of an overhaul.
What is a construction loan?
Construction loans are short-term loans that help you cover the costs of building a new home from scratch or planning a major renovation of an existing property. Construction loans are typically for 12-month terms, but some lenders offer alternative financing options for six-month, 18-month and 24-month projects.
How do construction loans work?
A construction loan can help you access the cash needed for the land, labor charges, building materials and more. However, you won’t receive the money in one lump sum. Instead, a lender will disburse funds throughout each phase of the building project: after the foundation is laid, the house is framed and the roof is finished, for example. You’ll make interest-only payments on the portion of the funds you’re using, so you’ll owe more as more cash is paid out over the course of the loan.
If you have a construction-to-permanent loan (more on this below), you don’t have to pay back the full amount when the construction loan term ends. The construction loan converts to a traditional mortgage that gives you an extended amount of time to pay off the entire property.
What’s the difference between a construction loan and a mortgage?
A construction loan typically lasts for one year, and borrowers pay only interest on the balance owed to the bank. A mortgage, on the other hand, often spans 30 years (or less depending on the term). And while the construction loan is designed to pay someone to build the property, a mortgage is designed to help you eventually own the property.
Both types of loans involve a lot of paperwork, but construction loans require more documentation and lender protocols. In addition to reviewing your finances (pay stubs, tax returns, bank account statements, etc.), a lender must approve a detailed overview of the building process, estimated costs and timeline for the project’s completion.
Types of construction loans
All home projects are not created equal. Depending on your needs, there are a few different construction loan options that may be a good fit.
Construction-to-permanent loans
If you’re going to need to borrow money to actually buy a home when it’s done (which most people do), a construction-to-permanent loan converts to a mortgage after the project is completed. This way, you only deal with one application to borrow the money and one set of closing costs. Borrowers pay lenders only interest over the course of the construction loan, but will have to make payments covering both the principal and interest once a construction loan becomes a mortgage.
Construction-only loans
Construction-only loans are appropriately named: The money only covers the construction phase. When the term is up, you need to pay back all of the money. And if you need to take out an additional loan to make that happen, you’ll need to pay another set of closing costs. That’s why construction-to-permanent loans are more common among borrowers who plan to live in the home when it’s done.
Renovation loans
If you’re planning to buy an existing home that needs a lot of work, renovation loans let you borrow money based on the expected value of the property after you fix it up. These loans let you borrow all the money you need at the beginning without worrying about converting the loan or paying off a construction-only loan. Keep in mind that there may be some restrictions around your renovation project, depending on the type of financing you use. For example, the federal government’s FHA 203(k) program doesn’t allow luxury upgrades such as swimming pools.
Owner-builder loans
With this financing arrangement, the borrower acts as the contractor and does some of the building work on their own. This kind of DIY approach to building a home comes with much bigger risks for lenders, so this option isn’t widely available. In exchange for saving some cash, you’ll need to be able to show a lender that you are qualified to handle the complex process of building a new home.
Pros and cons of construction loans
Paying to build a new home will be one of the most expensive transactions you’ll ever make. Before you start comparing construction loans, think about the main advantages and drawbacks.
Pros
Build what you want now -- not later: Construction loans allow you to build something you love now instead of buying something you’ll have to later.
Affordable payments: The ability to make interest-only payments over the life of the loan is good news for your budget.
Some flexibility: With construction-to-permanent loans, you can automatically convert your loan into a mortgage – keeping your closing costs in check.
Cons
No wiggle room: If your project goes over budget, you’re going to have to pay the difference out of pocket.
Higher rates: Construction loans tend to have higher interest rates than traditional mortgages.
Potential for two sets of closing costs: If you don’t have a construction loan that converts to a permanent mortgage, you’ll need to pay another set of closing costs and fees on a brand-new loan.
How to get a construction loan
Getting a construction loan is a bit more complicated than getting a traditional mortgage. Instead of clicking on a preapproval link and inputting a few pieces of information about your cash flow, you’ll need to have a solid idea of the builder you want to work with and the overall scope of the project.
The National Association of Home Builders has a directory of contractors to start searching for someone to handle your project. Make sure the builder has builder’s risk insurance, too, to help protect against theft, vandalism or severe weather that can lead to losses or damages on the job site.
In addition to comparing a number of different builders, it’s important to shop around for lenders too. Some lenders offer float-down features that let you lower your interest rate below your locked-in mortgage rate if the market changes.
Construction loan requirements
Requirements for construction loans vary by lender, but you’ll need to meet some of the same qualifications of other loans to score the best terms: a high credit score and a low debt-to-income ratio. Additionally, you’ll need to have money set aside for a down payment.
Most lenders will require at least a 20% down payment, but some accept less for construction loans. Don’t forget to budget for closing costs, either, which can add thousands -- and in some cases, tens of thousands -- of dollars to your upfront needs.
In addition to having the money set aside, ask your lender for an itemized list of every document you need for approval. Construction involves contracts with the builder, project plans and budgets, proof of insurance, and more.
Construction loan rates
Rates for construction loans have historically been a bit higher than rates for buying existing homes. However, some builders are making the price tag for a new home look more attractive to potential homeowners. According to the National Association of Home Builders, more than half of builders offered some type of incentive to attract buyers in June, such as rate reductions that effectively buy down the rate for the first few years, and others might cover your closing costs.
Rates will vary from lender to lender, and some lenders offer both fixed-rate and adjustable-rate mortgages for construction loans.
The bottom line
Construction loans are a bit more complicated than standard mortgages, but they can be well worth it. After all, you’ll be able to build your dream home rather than moving into a home designed by someone else. And in today’s high-rate market, new construction might be a better route toward homeownership since so many current owners are hesitant to sell.