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Home Construction Loans: The Basics

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Home Construction Loans: The Basics
5 min. read

Image: Jat306 / Shutterstock.com

Why buy a house when you can build your own dream home? One question you may have, however, is how to finance it? Few of us have the cash outright, so it’s likely you’ll need to take out a loan. While a typical mortgage won’t cut it, a construction loan possibly will.

What is a construction loan?

A construction loan enables those who want to build their own home to do so, without having to foot the bill themselves. These are often short-term loans that are only used to cover the costs of building a home, and once the project is complete, they must be repaid. However, you can typically refinance and take out a standard mortgage to cover the cost — this is generally called an end loan.

How do I qualify for a construction loan?

Obtaining a construction loan is a far more difficult process than obtaining a regular mortgage, and lenders set extremely strict terms and conditions that must be met before the loan is approved. This is because the lender is required to put a lot of trust in the borrower and their builder. They’re essentially lending money for something that doesn’t yet exist, and unlike a conventional mortgage, they have no collateral.

Any number of things could go wrong along the way, and the chances of not making their money back are much higher. To mitigate the risks, lenders impose strict qualifying conditions on construction loans:

  • A qualified builder must be hired: the lender will insist that only the most experienced, qualified and licensed builders/general contractors are involved in the project. They will need to have a great track record of building quality homes to budget and on time, as well as a healthy credit score. Such professionals don’t come cheap, and if you were planning to manage the project yourself, you might struggle to obtain financing.
  • A watertight plan and budget is essential: before applying for a loan, it’s imperative that you, your architect, and general contractor draw up accurate plans that detail everything from dimensions to materials. A solid budget must be calculated, as well as a clear time frame. The lender will carry out checks to see if your plans and budget are realistic.
  • Large down payment: expect to need around 20% for your down payment, though some lenders may ask for more or less.
  • Appraisal: even though your home hasn’t been built yet, you’ll need to have the potential value appraised. The appraiser will study the plans and specs, the value of the land, and comparables in the neighborhood to arrive at the estimated value of your home.
  • Safety net: borrowers should also have proof of additional cash in the bank, that can be used in case the project goes over budget.

Many of these qualifications actually protect you in the long run and ensure your plans are reasonable and realistic, and that your estimated budget is adequate. On top of these specialist qualifications, you’ll also have to provide all the standard documentation, such as credit reports, tax documents, payslips, etc. Being organized is key!

How do construction loans work?

While difficult to obtain, construction loans actually work in a very user-friendly way, protecting both the lender and the borrower. Your loan is taken out in a series of payments known as ‘draws’, which are paid to the builder in order to fund the project. The first draw is normally taken from the down payment to reduce the risk to the lender.

The payout schedule is determined by the lender (look for lenders that specialize in construction loans) going over the plans, and discussing the options with you and your builder. For example, there may be four payments of 25%, or 10 payments of 10%, to be paid out at different stages of the project. Before each draw is authorized, the project is normally inspected by the lender, to ensure the money is being spent as agreed, and that the project is on schedule.

When all the draws are paid, the borrower will typically need to set up an ‘end loan’, which can take the shape of a typical mortgage, in order to pay off the construction loan. This is easier to take out once the construction is complete as the lender has a physical asset to use as collateral.

Variable interest rates

Construction loans are almost always subject to variable interest rates, and will fluctuate with the prime rate. The rate is normally equal to the prime rate, plus a certain amount, which can be great if rates fall, but less so if they rise. Most construction loans are set up as interest-only loans, meaning the borrower is only required to pay interest on the amount that has already been paid out.

You still make monthly repayments, but they will typically start out lower, and increase as more draws are paid out. For example, if you take out a loan of $150,000, and agree to 10 draws at 10%, you will only pay interest on $15,000 initially, going to $30,000 after the first draw, and so on.

Two types of construction loans

If you’re in the market to build your own home, there are two types of construction loans to be aware of:

  • Construction-to-permanent loans: this loan starts as a variable rate construction loan, and will switch to a standard mortgage via the same lender once construction is complete. There’s only one closing, and you can typically lock in a fixed rate for the mortgage from the beginning. This is the most popular choice, though a larger down payment is normally needed.
  • Stand-alone construction loans: a standard construction loan that leaves you free to take out an end loan with another lender once construction is complete. They normally allow smaller down payments than construction-to-permanent loans, but you’ll need to pay closing fees on two separate loans. They’re also riskier, in that if your financial circumstances change during construction, there’s no guarantee that you’ll qualify for an end loan.

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