What Are the Requirements for a Construction Loan?

If you want to build a home from the ground up, a construction loan can help finance the land, labor, materials and other costs needed to complete the project. Unlike a standard mortgage, construction financing is typically released in stages as work progresses, and lenders generally require detailed plans, a qualified builder, an appraisal and proof that you can afford the project. Down payment and credit requirements can also vary considerably depending on whether you use conventional or government-backed financing. Understanding those requirements before you start building can help you compare loan options and avoid financing problems during construction.

If you want help getting your finances in order to plan for this, consider working with a financial advisor.

How to Get a Construction Loan

Construction loans, particularly for large and costly building projects, require a great deal of pre-planning and vetting before a bank hands over the cash. There are several requirements a borrower must fulfill to assure the lender of a good investment.

1. A Qualified Builder and/or Construction Team

To finance a homebuilding project, you will generally need to identify the builder or general contractor who will complete the work. Lenders commonly review the builder’s qualifications, licenses, insurance, experience and track record before approving the project. They may also request a construction contract, references or information about previous projects.

Requirements vary by lender and loan program. For example, FHA construction-to-permanent financing generally requires the borrower to contract with a licensed general contractor. A borrower may act as the general contractor under the FHA program only if the borrower is also a licensed general contractor.

Owner-builder financing is available in some situations, but it can be harder to obtain because the lender assumes more risk when the borrower is responsible for managing construction. If you want to serve as your own contractor, ask prospective lenders about their experience, licensing and documentation requirements before making plans around that option.

2. Detailed Description of the Construction Plan

No established lender will finance a substantial construction project without detailed information about what will be built and how much it is expected to cost. The exact documentation varies, but lenders commonly require a construction contract, architectural plans and specifications, site or plot plans, a detailed budget and a construction timeline.

You may also need to provide information about materials, subcontractors, permits and the schedule for completing different phases of the project. Rather than relying on a document universally known as a “blue book,” borrowers should ask the lender for its specific construction-document checklist.

The lender will use this information to underwrite the loan, order the appraisal and establish how construction funds will be released. During the construction phase, money is generally disbursed through a series of draws rather than paid to the borrower all at once. The lender may require inspections before releasing additional funds to confirm that work has progressed according to the plans.

3. Appraisal

Construction workers looking at a blueprint.

An appraisal is an important part of construction financing because the completed home does not yet exist when the loan is underwritten. The appraiser therefore generally evaluates the property’s anticipated “as-completed” value using the construction plans and specifications, the plot of land and comparable completed properties.

Depending on the loan program, the maximum mortgage may be based on the lesser of the project’s documented cost or its as-completed appraised value. That means a low appraisal can affect how much a lender is willing to finance even if your construction contract calls for a higher total cost.

The lender may also require a final inspection or other documentation after construction to confirm that the home was completed according to the plans and specifications before the loan converts to permanent financing or the final funds are released.

4. Sizable Down Payment

Construction loans can require more borrower equity than a typical purchase mortgage, but a 20% or 25% down payment is not a universal rule. The amount you need depends on the lender, property, loan structure and whether you qualify for conventional or government-backed construction financing.

For example, eligible Fannie Mae single-closing construction-to-permanent loans can have loan-to-value ratios as high as 95%, potentially allowing a much smaller borrower contribution than 20%. USDA’s Single Family Housing Guaranteed Loan Program also offers qualifying borrowers single-close construction-to-permanent financing with up to 100% financing in eligible rural areas. Eligible veterans may also be able to use VA construction financing, subject to VA and lender requirements.

If you already own the land, its value may also affect the loan-to-value calculation and the amount of cash you need to contribute, depending on the program.

Regardless of the down payment, lenders will evaluate your ability to repay the loan. Expect underwriting to include your income, debts, credit history, assets and the projected cost and value of the completed home. Because construction projects can run over budget, lenders may also require reserves or a contingency amount to cover unexpected costs.

Types of Construction Loans

Not all construction loans are structured the same way. There are several different types of loans available to choose from, so you can find the one that best aligns with your project goals, budget and repayment timeline.

Construction-to-Permanent Loan

A construction-to-permanent loan combines construction financing and the eventual standard mortgage. With a single-closing version, the borrower generally closes before construction begins and the financing automatically converts into a long-term mortgage once the home is completed and applicable requirements are satisfied.

This structure can reduce the need for a second set of closing costs and can allow the permanent financing terms to be established before construction begins. During construction, the lender typically controls disbursements to the builder or other approved parties through scheduled draws.

Some programs may require updated income, employment, credit or appraisal documentation before conversion if construction takes long enough for the original documents to expire.

Construction-Only Loan

A construction-only loan finances the building phase but does not automatically become the borrower’s permanent mortgage. Once the project is finished, the borrower generally must pay off the construction loan, often by obtaining a separate mortgage or refinancing.

Because the permanent loan requires a separate closing, the borrower may face a second set of closing costs and must qualify again based on the lender’s underwriting standards at that time. There is also interest-rate risk if mortgage rates rise before construction is complete.

Owner-Builder Loan

An owner-builder loan allows the borrower to take responsibility for managing construction rather than hiring a traditional general contractor. These loans can be difficult to qualify for because lenders may require the borrower to have substantial construction experience, licensing or professional credentials.

Requirements also depend on the loan program. FHA construction-to-permanent financing, for example, generally allows a borrower to act as general contractor only when the borrower is a licensed general contractor. Borrowers considering this structure should verify the lender’s owner-builder requirements before beginning the project.

Renovation Loan

Renovation financing is designed for an existing property that needs repairs or improvements rather than a home being built entirely from the ground up. Depending on the program, the mortgage can combine the purchase or refinance of the property with money set aside for renovations.

Options include the FHA 203(k) program and conventional products such as Fannie Mae’s HomeStyle Renovation mortgage. FHA currently offers both Standard 203(k) financing for larger rehabilitation projects and Limited 203(k) financing for qualifying nonstructural improvements of up to $75,000.

Renovation funds are typically held and released as work is completed, and lenders may require contractor documentation, cost estimates, inspections and an appraisal based on the property’s expected value after the improvements.

End Loan

An end loan is the permanent mortgage used to replace a construction-only loan once the home is complete.

Because the borrower applies for the end loan separately, the lender can require new underwriting, credit documentation and an appraisal. The rate and terms available when construction is finished may also differ from what the borrower expected when the project began. Borrowers using construction-only financing should therefore consider how they will qualify for permanent financing before committing to the build.

Bottom Line

A couple examining the construction work that they will have to complete.

Getting a construction loan generally requires more preparation than getting a mortgage for an existing home. Lenders may review your builder, construction contract, budget, plans and specifications before approving the loan, and the home’s expected value is typically evaluated through an as-completed appraisal. Funds are then released as construction progresses rather than all at once.

Financial Management Tips

Construction loans can be complicated, but working with a financial advisor can make it much easier. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
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