How Do Construction Loans Work, and What Are The Requirements?

How Do Construction Loans Work, and What Are The Requirements?

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If you don’t have the funds on hand to build your dream home, you’ll need a construction loan. How do construction loans work? They’re different from traditional home loans in terms of how funds are distributed and how the loan is structured. Construction loans are short-term loans that cover the cost of building a home. Learn more about how construction loans work.

What is a construction loan?

A construction loan is a short-term loan that funds building a home. These loans are typically for less than one year, and the funds are paid out in a series of installments, known as "draws," while the home is being built.

You may also be able to convert the loan into a conventional mortgage, which is referred to as a construction to permanent loan. If the loan doesn’t automatically convert, you’ll need to reapply for a loan and provide updated income information and other documentation.

How do construction loans work?

Construction loans are a bit more complicated than traditional home loans. Instead of receiving funds as a single lump sum, it’s paid out in draws. These draws correspond to different phases of the construction process. For example, there might be draws for:

  • Delivering the final plans for the home, getting permits and completing the foundation
  • Framing out the home
  • Installing all the drywall, siding, windows and doors
  • Installing HVAC systems, electricity and plumbing
  • Installing interior trims, cabinets, countertops and flooring
  • Substantial completion of the home
  • Final completion of the home
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Draws may also be based on the percentage of a particular project completed. Your lender will determine the draw schedule.

Common construction loan requirements

Construction loans are riskier for lenders, so the process of being approved for one is, understandably, more complicated. Here’s what lenders consider.

  • Your credit score
    Your credit score: Just like with a traditional mortgage, your credit score is important to lenders. The minimum credit score for most conventional and USDA construction loans is 620. VA construction loans don’t have a required minimum, but lenders are generally looking for a score of at least 620. FHA construction loans required a minimum score of 580.
  • Down payment
    Down payment: While you might expect a higher-than-normal down payment on a construction loan, they’re actually comparable to traditional mortgages. FHA construction loans have a minimum down payment of 3.5% for HUD-approved projects and 10% for projects that aren’t HUD approved. VA constructions loans don’t have a down payment, USDA construction loans have a minimum down payment of 10% and a conventional construction loan down payment is typically 5% or more.
  • Construction plan and specs
    Construction plan and specs: Lenders will also want to know the ins and outs of what you’re planning to build. They’ll need a blueprint of the house and specs, and the plans will need to be certified as meeting all the required building codes in your area. A home appraiser will need to review those specs to decide its value, which dictates the amount your loan will be.
  • Construction contractor and lender review
    Construction contractor and lender review: In most cases, unless you’re a licensed general contractor, you’ll need to hire one to build your home. Lenders will also look closely at the contractor involved in the building, so it’s critical to choose an experienced one. Your contractor is an important partner in the process. The lender will need to know the budgets and cash flow projected for the project. Lenders will typically also need to review and approve the construction contract between you and your contractor.

Different types of home construction loans

Lenders offer different types of construction loans.

One time close

A one-time close construction loan, also known as a construction-to-permanent loan, automatically converts the construction loan into a long-term mortgage when the home is built. You only have to complete one application and close the loan once. That also means you only have to pay closing costs once. You’ll typically make interest-only payments during construction and then start making full payments on the principal and interest once it converts to a mortgage.

Two-time close

With this type of loan, you have one loan for the construction phase and another loan for the mortgage phase once the house is completed. The second loan pays off the construction loan. This gives you the option of shopping for the best rates and terms for each loan, but you do have to apply for two loans and go through two closings, each with closing costs. You won’t be able to lock in your mortgage rate until the home is near completion. This type of loan makes sense if you’re confident that your financial situation won’t change during the often lengthy construction process, and you don’t mind shopping for two loans.

Owner builder

If you’re experienced in construction, you may be eligible for an owner builder loan. These loans allow you to eliminate one of the most expensive parts of home construction — hiring a general contractor. You will need to act as a general contractor, however, and manage the entire process. This gives you more control over the process, but it also requires a significant time commitment. These can be one-time close construction loans.

Construction loan interest rates

Not every lender offers construction loans. Your best bet is to talk to local banks and credit unions. Construction loan interest rates tend to be a bit higher than traditional mortgage rates, as these loans are significantly more complex and risky for the lender.

Given how long it takes for construction to finish, you might be concerned about interest rates changing while construction is underway. Some lenders do offer a long-term rate lock option. You will need to pay for the lock, and some lenders require an upfront, non-refundable deposit. For example, you might pay one point for a 360-day lock, with a requirement to pay 0.5 points upfront. The rate lock may also include a float-down provision that allows you to get a lower interest rate if they drop significantly.

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