Construction Loans: What They Are and How They Work

Building a home gives you an opportunity to have everything you could possibly want in a home — within your budget, of course. You don’t have to be rich to make it happen, you just have to qualify for a construction loan.

Construction loans are different from traditional mortgages. For one, a traditional mortgage is a long-term loan that helps you pay for an existing home, whereas a construction loan is a short-term loan that pays for the building of a new home and can convert into a traditional mortgage once the building process is completed.

Here’s what you need to know about the different types of construction loans and how they work:

What is a construction loan?What does a construction loan cover?How do construction loans work?Construction loan ratesConstruction loan typesHow to get a construction loanIs it hard to get a construction loan?How to choose a construction loan lender

What is a construction loan?

A construction loan allows you to borrow money to build or renovate a home.

When you buy a move-in ready home, the mortgage only needs to cover the purchase price and sometimes the closing costs.

When you build a home (or buy a home you want to overhaul), there are more steps involved: buying land, paying contractors, passing inspections. This more complicated process warrants a different type of loan.

Learn More: How Much It Costs to Renovate a House

What does a construction loan cover?

Construction loans pay for costs like:

LandArchitectural plansDesign feesBuilding permitsConstruction materialsContractor laborContingency reserves (in case your project goes over budget)Interest reserves (to cover your interest expenses during construction)Closing costsLong-term financing once construction is complete

How do construction loans work?

A construction loan is designed to pay for work in stages. This arrangement, called a “draw schedule,” reduces the risk to both the borrower and the lender that the builder will get a huge sum up front and fail to complete the work.

It also reduces the risk of shoddy work, as the lender will require inspections after each phase of building before releasing more funds. In fact, construction lenders require borrowers to work with experienced builders that do a high volume of work and that are financially sound, licensed, and insured.

While you won’t find construction loans at Credible, we can help you secure a competitive rate on your next conventional mortgage. In just a few minutes, you can compare loan options from all of our partner lenders — it’s easy and free.

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Construction loan rates

Construction loan interest rates vary by lender, but can be similar to existing home loan rates or a few percentage points higher. Having a strong borrower profile (such as an excellent credit score and debt-to-income ratio) and working with a lender that specializes in construction loans will help you qualify for the best possible rate.

Construction loans can have either a fixed or variable interest rate during the construction phase. If you choose a construction loan with a variable interest rate, it’s important to understand the range within which your interest rate can fall and when you’ll be able to lock the rate on your permanent (post-construction) mortgage. That said, permanent loans can have adjustable rates, too.

If you don’t want that uncertainty, seek out a construction-to-permanent loan with a fixed rate so that the rate stays the same during the construction phase and permanent phase.

Learn More: How Much Does It Cost to Build a House in 2021?

Construction loan types

There are several types of construction loans. Learn which type might be right for you.

Renovation loan

A renovation loan is a type of construction loan that helps you buy an existing home and pay for any major structural and aesthetic changes. Examples of renovation loans include the FHA 203(k) loan and the Fannie Mae HomeStyle loan.

The key difference between a renovation loan and a regular purchase loan is that it gives you money to buy the home as well as to fix it up. This may mean borrowing more money than the home is currently worth.

Good to know: Real estate investors will often use a renovation loan to buy a fixer-upper. The idea is to bring the home’s value up through renovations, ideally to a higher value than the amount borrowed for instant equity.

Construction-to-permanent loan

Similar to a renovation loan, a construction-to-permanent loan combines what would normally be two loans. It gives you both money to build the home and the long-term financing to pay for the home over time.

Instead, you’ll have one loan with one closing, one appraisal, and one set of closing costs. Plus, you’ll only have to qualify once. If your financial situation changes while your home is being built, you’ll still be able to move in.

Good to know: You’ll make interest-only loan payments during construction (or borrow extra to cover this expense) and principal and interest payments after construction.

A construction-to-permanent loan will also allow you to finance the purchase of the land if you don’t already own it. Or, if you have an existing lot loan, you can use a construction-to-permanent loan to pay it off.

FHA construction loan

Borrowers with smaller down payments and lower credit scores may want to consider an FHA construction loan. These loans require a borrower contribution of just 3.5%. You can use your land equity toward your down payment if you’ve already purchased the land you’ll be constructing your home on.

The FHA’s construction loan has a single closing (meaning it’s a construction-to-permanent loan) and doesn’t require you to make any payments during the construction process. The interest rate may be fixed or variable during construction.

The FHA also allows you to be the homebuilder if you’re a licensed general contractor. The minimum credit score to qualify tends to be 620 or 640, depending on the lender.

Important: FHA loans come with additional fees, including upfront mortgage insurance and monthly mortgage insurance premiums.

VA construction loan

Qualifying military service members with VA loan eligibility may want to consider a VA construction loan to build a home. These loans allow up to 100% financing that covers both the land and home construction.

The VA guarantees two types of construction loans:

One-time close loan (construction-to-permanent)Two-time close loan (a construction loan followed by a separate permanent loan)

As its name suggests, a two-time close loan involves two separate closings and, in turn, requires you to pay two sets of closing fees.

When you get a VA construction loan, you won’t make any payments during the construction phase. Instead, your loan term will be shortened by the length of the construction period. If it takes a year to build your home, you’ll pay it off over 29 years instead of 30.

Good to know: You must use a registered VA builder. Lenders are allowed to charge a construction fee of up to 2% of the loan amount plus a 1% origination fee.

The VA requires the builder to cover a number of fees that borrowers might pay on other construction loans, such as loan interest during construction, inspection fees, and hazard insurance premiums. Like other VA loans, the veteran must pay a VA funding fee.

Owner-builder construction loan

If you’re a professional builder and want to construct your own home, you can get an owner-builder loan by proving that you’re experienced, licensed, insured, and have a financially sound business. You’ll also need to meet the standard personal financial requirements.

This type of loan may be attractive if you want the cost savings, control, and personal satisfaction of building your home yourself.

Tip: The VA doesn’t guarantee this type of construction loan, but the FHA does. You can also get an owner-builder construction loan from a private lender.

One-time close construction loan

A one-time close construction loan (also called a single-close construction loan or construction-to-permanent loan, as discussed above) is any construction loan where a single loan covers your entire project. For example, a VA construction loan can also be a one-time close construction loan.

Over the months it takes to build your home, your financial situation and interest rates may change. These changes can affect loan costs and your ability to qualify for a permanent loan. In addition, each loan requires its own down payment, underwriting, and closing costs.

Tip: A single-closing loan can save you a lot of time, money, and uncertainty. Without this type of loan, you might need three loans: one loan to finance the lot, a second loan to build the home, and a third loan to pay off the first two loans plus the home itself.

Learn More: Buying New Construction: Pros, Cons, Step-by-Step Guide

How to get a construction loan

Like with any home loan, you’ll need to meet a certain set of requirements to obtain a construction loan. Requirements vary by lender and by the type of construction loan you’re applying for.

Construction loan requirements

In general, here are the criteria you’ll want to meet to qualify for a construction loan:

Credit score: You’ll want to have a credit score of at least 620 to qualify for an FHA or VA construction loan. For a Fannie Mae single-close loan, the minimum credit score is 700.Down payment: For a conventional construction loan, you may need a down payment of as little as 5%. Sometimes you’ll need 10% to 20% of the sales price (land plus construction costs) or equity from your land value. An FHA construction loan requires a down payment of 3.5%, while a VA construction loan doesn’t have any down payment requirement.Debt-to-income ratio: Your DTI should be 43% or lower. A higher ratio may be allowed if you otherwise have strong finances.Repayment plan: Construction loans usually require no payments or interest-only payments during the construction phase. You’ll make fully amortizing principal and interest payments once construction is complete.

Steps to get a construction loan

Here’s how to get a construction loan:

Get pre-approved with a construction loan lender.Sign a contract with a builder. Make sure it has a loan contingency so you can exit the contract if you can’t finalize your construction loan.Submit your builder contract and the usual underwriting documents to your lender for approval. If you already own the land you will be building on, submit a copy of the deed, survey, and, if you bought the land recently, the settlement statement.Get a “subject to completion” appraisal for your proposed home.Get final approval and close on your construction loan.

After closing, construction can begin. Your lender will pay your builder through a series of disbursements and will inspect each phase of work.

Once construction is complete, your construction loan will be modified to a permanent loan or you’ll obtain permanent financing.

Is it hard to get a construction loan?

It shouldn’t be hard to qualify for a construction loan if you’re working with a reputable builder and you have a strong financial profile.

However, there are more steps in the qualification process, so it can be more involved and take longer than qualifying for a traditional mortgage.

How to choose a construction loan lender

The first thing you should look for when choosing a construction lender is expertise with construction loans. A lender that processes a high volume of construction loans and understands their intricacies will be easier to work with.

Chances are you have never built a home before, so you’ll want to choose a lender who can help you manage the construction process most effectively. A lender who has gone through the homebuilding experience numerous times will have a strong sense of how the process is supposed to work, what can go wrong and how to avoid problems. They can help you make sure your build gets done correctly.

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Gloria Stutler