What is a construction loan?

A construction loan is a short-term loan used to finance the construction of a real estate property. The property could be a single-family, multi-family, commercial building, or an entire apartment. One can use a construction loan to build his dream home or investment property. Lenders view construction loans as riskier than traditional mortgages as there is no asset to secure the mortgage while the house is being built. Therefore, the interest rate for construction loans is higher.

How do construction loans work?

The construction loan only covers the costs of building the house, the borrower will still need to get a mortgage after the house is built. Construction loans are short-term loans, and the term is usually for a year or two. There are different types of construction loans, and each has a different requirement. Some construction loans allow a borrower to pay only the interest while the house is under construction. Some loans require the borrower to pay off the loan once the project is completed, while others allow the borrower to refinance or get a new loan to pay off the construction loan.

Types of Construction Loans

Following is a list of the different types of construction loans.

• Construction-Only Loan - A short-term loan that covers only the actual construction period, usually 1 year. After the construction is done, the borrower will need to apply for a traditional mortgage to pay off the construction loan or refinance it. There are two application and loan approval processes involved with this type of loan, once for applying for the construction loan, and another for the long-term mortgage. The advantage of this type of loan is that you can shop around to find a lender that gives you a lower interest rate on the long-term mortgage.
  
  
• Construction-To-Permanent Loan - This type of loan allows the borrower to convert the short-term construction loan to a long-term mortgage once the construction is completed. The conversion process is automatic meaning a borrower will only need to be approved once, thus saving on closing costs. During the construction period, the borrower pays only the interest. However, the downside is that construction-to-permanent loans usually have a high-interest rate, and a borrower ends up with a high interest for their long-term mortgage.
  
  
• Renovation Loan - Instead of building a new house, a borrower takes out a loan to renovate or fix his own house. FHA 203(k) is one type of renovation loan that allows a borrower to upgrade their primary home. There are many other options that homeowners may consider to renovate their home, such as a home equity loan, home equity line of credit or cash-out refinance.
  
  
• Owner-builder construction loan - If a borrower is a licensed builder, he can build his own home instead of hiring third-party builders to build a house.
  
  
• End loan - An end loan is the regular mortgage that a borrower needs after the house is built and pays off the construction loan.
  
  

How to get a construction loan?

The best way to start looking for a lender to finance the construction costs of your house is to ask the banks. When you find the ones that do construction loans, make sure to compare their interest rate and the costs involved in closing the mortgage. Just like a traditional mortgage, lenders check credit scores to determine what kind of interest rate a borrower will be getting. The higher the score, the lower the interest rate. Most lenders do not accept borrowers with a credit score lower than 620. Many people spend their time designing their houses only to find out that they are not qualified for a construction loan. Make sure you check with the bank first to see if you qualify for a mortgage before you do anything else. The underwriting process for getting a construction loan is usually longer than a traditional mortgage as there are more parties involved, and the banks need to take their time evaluating the future value of your home. Borrowers will need to provide a detailed construction plan and a cost estimate. Your loan will not be approved until you provide these documents. Be sure to have a solid plan written down before you apply for a construction loan. Additionally, the borrower is expected to have a low debt to income-ratio or DTI. Lenders want to see the borrower has low debt so that they are able to make monthly payments to repay the construction loan.

Construction Loans FAQs

How much down payment for a construction loan?

The requirement for a construction loan is usually stricter than a traditional mortgage as they are riskier to the lender. Many lenders require the borrower to put in a minimum of 20% - 30% as a down payment.

Is it hard to get a construction loan?

Compared to a conventional mortgage, it is harder to get a construction loan. Not all mortgage lenders offer mortgages for construction loans because they are riskier than a traditional mortgage.

Do construction loans have higher interest rates?

Yes, construction loans usually have a higher interest rate than a conventional mortgage. It is a good idea to shop around and compare the interest rates of different lenders that offer construction loans.

Minimum FICO score for a construction loan?

To qualify for a construction loan and get a better rate, a minimum credit score of 680 is required. Although some lenders offer construction loans to borrowers with a credit score lower than 680, they face a much higher interest rate.

How to use the construction loan calculator?

The construction loan calculator requires only 3 variables, the loan amount, terms, and the interest rate. Loan Amount - the total amount of the construction loan Loan Terms - when will the loan be paid off Interest Rate - the interest rate for the construction loan The calculator will generate a construction loan amortization schedule that shows borrowers exactly how much they will be paying each month, what portion of the payment is for interest and others for reducing the principal. Some construction loans require the borrower to make interest payments only, in that case, you can use our interest only loan calculator.