A construction loan is a short-term, interim loan to pay for the building of a house. As work progresses, the lender pays out the money in stages.
Construction loans are typically short term with a maximum of one year and have variable rates that move up and down with the prime rate. The rates on this type of loan are higher than rates on permanent mortgage loans. To gain approval, the lender will need to see a construction timetable, detailed plans and a realistic budget, sometimes called the “story” behind the loan.
Under this type of loan, you borrow money to pay for the construction costs of building your home. Once the house is complete and you move in, the loan is converted into a permanent mortgage.
Because this format is basically a two-in-one loan, you only have one set of closing costs to pay, reducing the amount of fees you owe.
During the construction of your house, you only pay interest on the outstanding balance; you don’t have to worry about paying down the principal yet. Typically, you’ll have a variable interest rate during the construction phase, so the rate and your payment can fluctuate.
Once it becomes a permanent mortgage — with a loan term of 15 to 30 years — then you’ll make payments that cover both interest and the principal. At that time, you can opt for a fixed or variable-rate mortgage.
With this approach, you take out two separate loans. One is solely for the construction of the home, which usually has a duration of a year or less. Then, when you move in, you take out a mortgage loan to pay off the construction.
With a construction-only loan, you don’t need as large of a down payment. They can be a smart option for those who own a home and are building their next house. You may have limited cash now, but once your current home sells, you’ll have more money to pay the mortgage on the completed house.
Because home construction loans are more risky than traditional mortgages, not all banks or financial institutions offer them. It’s a good idea to look at several different lenders to review their requirements, rates, and loan terms. If you have trouble finding a lender willing to work with you, check out smaller regional banks or credit unions, which may be more likely to help.
Get pre-approved for the home construction loan before working with a contractor. If you can’t get approved for a loan, you don’t want to be out hundreds or thousands that you put into blueprints and design.
If you want to build a new home, you should know that you have a more difficult road ahead of you than if you pursued a traditional mortgage. Make sure you meet all of the lender’s criteria and that you have a significant cash cushion before moving forward.