Whether you’re building a new home or renovating an existing one, you may not have funds in the bank to cover all the costs. Luckily, you can borrow money to pay for this type of project with a construction loan.
What is a construction loan?
Construction loans are used to finance the building or renovation of a home (or other real estate projects). They cover the cost of the project before long-term funding—like a traditional mortgage—is obtained. Construction loans are short-term, high-interest, and typically last for one year.
How does a construction loan work?
Before you’re granted a construction loan you’ll need to provide your lender with a construction timeline, details, and budget. All of this information will factor into the final loan amount, as well as the draw schedule, a detailed payment plan
for your construction project.
Because a construction loan is used to pay for construction materials and labor, it’s doled out in what is known as draws or tranches, a series of payments that sync with different phases of the construction timeline. This schedule typically aligns with the completion of major milestones such as when the home’s foundation is laid, when plumbing is completed, etc. Your loan provider will decide what the draw schedule will be and will send an inspector to monitor progress of the build before approving the next draw.
For your draw schedule
, you will need to include a description of each step of the construction process, how much it will cost, and the percentage of the work completed. Here’s an example for a 2,000 sq. ft. new build home, according to Building Advisor:
In most cases, borrowers are only required to make interest payments on their construction loan during the build. Once the project is completed, the construction loan gets converted to a traditional mortgage (a construction-to-permanent loan), is paid in full, or a separate mortgage is created to pay it off.
How do I get a construction loan?
Since construction loans carry more risk than a traditional mortgage, interest rates tend to be higher. With a traditional mortgage, the physical house is used as collateral: If you don’t pay your mortgage, the lender can seize your home. Because no collateral exists for a construction loan, the lender will look more carefully at your finances, income, and credit score to confirm your ability to pay for the project.
Before applying for a construction loan, you’ll need to do a few things:
Find a licensed builder: This shows the lender that you’re hiring a professional, experienced home builder. Double-check the contractor’s previous work, references, and license number to ensure it’s still active.
Gather documents: Your contract with the builder, architectural plans, pricing, and personal financial information all need to be vetted by your lender. You’ll be asked to show you can provide a down payment of anywhere from 5% to 20%, as well as that you have sufficient income to continue paying the loan and interest. The documents required to apply for a construction loan are:
The lender will want to see that you have stable income and will actually be able to pay back the loan. They will also look at your credit score. Typically, the minimum credit score required for most USDA and conventional construction loans is 620.
Get pre-approved: This is the process that determines how much you can borrow. If your lender of choice does not approve your loan for the amount you were hoping for, you can either try a different lender or figure out how to lower your construction costs.
How do I pay back my construction loan?
There are a few options for paying back a home construction loan:
- End loan: After construction is completed, you can get a new loan to pay off your construction loan.
- Refinance: Take out a new loan—likely a permanent mortgage—usually at a lower interest rate. (With Welcome Homes, your construction loan converts to a traditional mortgage of your choice with no additional closing costs once a Certificate of Occupancy is issued.)
- Pay outright: Some construction loans require that the entire loan be paid in full by the time construction is completed.
You’re ready to build your home—now you just need the money. With a home construction loan, you can receive the funding you need to start building your dream home.