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How Do Construction Loans Work?

Construction Loans

Buying a home is no small decision, but when it comes to building a home, the stakes are even higher. Between finding the right contracting company, meeting building codes and figuring out your mortgage payments, building your home can quickly become a daunting task. A construction loan – essentially a sum of money you get to finance your building costs – can help you manage the financial aspects of this undertaking. 

What Is a Construction Loan?

When you buy a house, you secure a mortgage loan. But when you build a house, you will likely have to take out a more specific type of loan called a construction loan. Unlike mortgage loans that are often for a 30-year duration, construction loans are shorter-term. Because they are considered a financial risk to the lender, they typically have higher interest rates.

For construction loans, the lender pays the building contractor directly rather than giving the money to the homeowner. These payments come in periodic stages over the course of the building process. They arrive usually once the developers have met certain observable benchmarks. Once the builders have completed the home, the homeowner will typically have paid the loan in full. If not, the loan will be converted to a permanent mortgage on the part of the borrower.

The Different Types of Construction Loans

Much like with regular mortgage loans, one size does not fit all with construction loans. There a three main types of constructions loans you may encounter:

  • Construction-to-permanent loans
  • Stand-alone construction loans
  • Renovation construction loans

In a construction-to-permanent loan (also referred to as a single-close loan), you borrow money in order to pay for the construction of the home itself. Once you move into your new home, the loan automatically becomes a mortgage. At the time of your closing, you will cement your interest rate. For individuals with firm plans for their house’s construction, a single-close loan will provide an equally firm set interest rate that is unlikely to fluctuate.

The next main type, stand-alone (also referred to as “two-close”) construction loans, are actually two separate loans. Essentially, your first loan will pay for the construction. Once you complete the house and are set to move in, you will get a mortgage. That second loan is to pay off the debt you incurred from construction. Stand-alone construction loans are right for you if you have substantial cash on hand. Ditto if you’re not set in a relationship with a lending bank by the time building commences.

The third main kind of construction loan is called a renovation construction loan. With a renovation construction loan from a trusted lender, individuals may pack the costs of the entire construction and renovation into the final mortgage. The projected value of the house after repairs and renovations will determine the size of the loan. These are primarily for individuals looking to purchase a house in need of substantial repairs. We often refer to these homes as “fixer-uppers.”

What Do Construction Loans Cover?

Construction Loans

Construction loans can be of great assistance to any individuals or families looking to build the home of their dreams, rather than purchasing an existing model. Even so, a construction loan covers a multitude of different home-owning initiatives.

Most notably, this list includes the purchase price of the plot of land on which you intend to build your home and the cost of closing the deal. Additionally, many lenders will include a clause providing money for so-called”soft costs” like house plan design fees, mechanical engineering and work and land permits.

Construction loans cover a vast array of costs. They can apply to numerous house purchase and revamp needs, and they cater to first-time home builders. Thus, they might be an attractive option for your own project.

The main differences between the types of construction loans spring from whether the borrower is building a new home or renovating an older one. In the case of a new build, your lender will want to ensure that you are in a solid place financially and that you have concrete and achievable plans for your house.

Once your lender considers you a viable candidate, he or she will provide the construction loan. You get the money in periodic installments as your home’s building process takes form. If you’re more inclined to spruce up a fixer-upper, the loan will instead be factored into your permanent mortgage.

Bottom Line

Construction Loans

Simply put, construction loans work by enabling first-time house builders with adequate credit scores to execute their project plans. As always, the relationship between the lender and the borrower is key. Communication on the part of the lender, the borrower and the builder is of paramount importance.

As with any loan, consider carefully the terms of the loan and its impact on your finances. It’s also a good idea to work with a financial advisor to see how it fits into your financial plan.

Tips for Managing Your Finances 

  • If you’re interested in taking out a construction loan, but are unsure of whether your current finances will allow it, get the answers you need from a financial advisor. Luckily, finding the right advisor that fits your needs doesn’t have to be hard. SmartAsset’s free tool matches you with financial advisors in your area in 5 minutes. If you’re ready to be matched with local advisors that will help you achieve your financial goals, get started now.
  • Building the house of your dreams can be an incredible experience, but if you aren’t careful, it can also break the bank.  Be proactive, and before you build, set up a savings account. This way, you can set aside funds in case unexpected needs arise.

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