What Is a Construction Loan?

A construction loan can assist you in financing the building process, whether you’re working with a contractor or doing it yourself.

Building your ideal home might be the best option if you cannot find one that satisfies your requirements. However, you cannot get a conventional mortgage loan for house that is still being built. You should seek construction financing instead.

By obtaining a construction loan, you can get financing to pay for the costs of building your custom house. The average time to pay back these loans is less than a year, during which you only have to pay the interest.

After that time, you can either get a regular mortgage loan to pay off the construction loan or have the construction loan turned into a regular mortgage loan.

How do construction loans function?

A construction loan is a short-term loan that uses your property as security, much like a mortgage loan. The money can be used for the land, contractor labor, permits, and materials.

An estimated budget and project timetable must usually be given to the lender. The lender would then disburse the loan money in installments as various project phases are finished.

However, the interest rates for construction loans are frequently flexible and change along with the market rates.

During the initial phase, you will typically make interest-only payments, but after that, the loan’s principal balance will be due. After that, you would start paying principal and interest.

Construction loans are riskier for lenders than standard mortgage loans because there isn’t a home at the beginning of the process, so you may anticipate a higher interest rate.

You should apply for a new mortgage to pay off the construction loan, depending on the construction loan you acquire. Alternatively, it might automatically convert to a conventional mortgage loan, rolling that sum into a 15- to 30-year payback term.

Construction Loan Types

You can pick from a few different forms of building financing. A brief rundown of your options is provided here.

Construction-only loan: If you choose this option, your loan will only be used to pay for the building supplies and other related costs. You will have to pay two sets of closing expenses since, after the repayment period, you’ll need to get a conventional mortgage loan to pay off the construction loan.

Loan for permanent construction: You can finish the home’s construction with this loan. Your financing will then automatically convert to a mortgage loan whenever you’re ready to move in, which usually has a term of 15 to 30 years. Tom Bond, the construction sales manager at Planet Home Lending, says that a construction-to-permanent loan makes sense when you want to build a large, unique, or unusual home. That kind of housing is frequently ineligible for conventional financing.

Owner-builder loan: With this choice, you construct the home yourself instead of hiring a contractor. Getting this kind of loan will require a contractor’s license. If not, it may be challenging to locate a lender who will give you financing.

Construction loan advantages and disadvantages

Consider both the advantages and disadvantages of construction loans. Here are some things to consider if you are considering using one to pay for new home construction loans.

Pros

Project-based financing: Depending on your plans for your dream home, you can find a lender who will meet your needs and work within your timeframe.

Initial interest-only payments: You only have to pay the interest on the loan while it is being built, which gives you some financial flexibility. That extra money in your budget may be handy if you borrow a construction loan while making a mortgage or rent payment for an existing property.

Strengthens your dream. Building your own home would be relatively inexpensive with construction financing options as you cannot obtain a typical mortgage loan. According to Bond, a construction loan enables you to purchase the same house you desire in the specific neighborhood where you would like to reside. You are not required to buy an existing home or follow a builder’s design in development.

Cons

Costly: Construction loans frequently have higher, variable interest rates since they pose a greater risk to the lender.

You’ll incur two closing costs if you don’t choose a construction-to-permanent loan.

Progress determines the need to fund: You won’t receive a single payment for your construction loan; instead, you will receive several draws as the project develops. If you or the contractor follow the schedule, money may be timely, but problems may arise.

They are less frequent: Construction loans are available from local and national lenders, so you should be able to locate one quickly. However, as these loans are less common than conventional mortgage loans, you might have fewer options.