How Do Construction Loans Work?

Everyone dreams of building a brand new home from the ground up to their exact specifications. However, many believe this dream is too far-fetched and simply out of reach. Could it be because of all of the complexities associated with construction loans, the lack of qualifications or not knowing where to begin? Basically, construction loans provide new homeowners with the money needed to build a home from the ground up.

Construction loans are not like standard mortgage loans. They are usually short-term loans that have a maximum of about one year to be repaid or however long it takes to build the home.

Construction loans are offered with variable interest rates that, in most cases parallel with the prime rate. A construction loan is often referred to as an interim loan, which is used to cover the costs associated with building a home from the ground up.

Construction loans are not disbursed in one lump sum but in stages; based on the progress that is being made as the house is being built. As contractors make progress towards completing the home, part of the construction loan is paid out. Once the home has been built and the construction loan has been fully disbursed, it is then transitioned into a mortgage loan. This process may seem simple enough, however, it’s quite different than simply applying for a regular mortgage loan.

When applying for construction loans, the borrower must also meet additional requirements, such as a higher credit score than regular borrowers, a larger down payment, and proof of a well-put-together project plan.

There are basically two types of home construction loans. Each of them will be explained in more detail below along with more details about the information mentioned above.

Obtaining a construction loan is a very serious endeavor. It should not be entered into lightly. Adequate planning and preparation should take place beforehand with qualified professionals to assist you with the application process.

How Construction Loans Work

If you’re planning to build a home from the ground up, you likely have already considered either the plot of land or the general neighborhood where you’d like your home to be developed. As a result, many construction loans also include the price of the land in addition to the cost of the construction.

Lenders Involvement

Although this may be a convenient option, it also adds more complexity to the overall process. The construction loan process then becomes a lot more hands-on by the lender. Here’s what I mean. Unlike a standard home loan, a construction loan will require lenders to review the plans that you have for your new home. Most of these plans include things such as an estimated budget as well as an estimated work schedule. This information is necessary because it helps lenders determine how much money is needed for the loan and how frequently disbursements need to be made.

Making Disbursements to Cover Construction Costs

After you have been approved for the loan and it has been secured, payments are made directly to the builder in various intervals. These intervals parallel that of each phase associated with the construction of your home. The frequency of the payments are organized into what banks referred to as a draw schedule. The draw schedule is normally a decision that is made among the lender, the builder and you, the homeowner.

During each stage of the development process, the lender confirms the progress of the construction that was made during the previous phase before making any additional disbursements.

During the construction process, borrowers only need to make interest payments. The repayment of the original loan amount starts after the home is completed. Upon which, the loan payments are transitioned to a traditional mortgage loan. There are ongoing monthly payments based on the traditional amortization schedule.

Types of Construction Loans

There are basically two different types of construction loans that a borrower can consider. The first is called a stand-alone construction loan, which is similar to what was just described above. The second type of construction loan is called a construction-to-permanent loan. In most cases, each of these types of construction loans includes the cost of the land, but not in all cases. Either way, it’s important to make sure you are fully aware of all the expenses your lender will finance on your behalf. It’s also important to be fully aware of the origination process when working with certain lenders as well.

The Stand-alone Construction Loan

With a stand-alone construction loan, a separate mortgage loan is needed after the construction has been completed.

Typically, the lender provides the initial loan as an advancement for construction purposes only. During this time, only interest payments are required by the borrower. The remaining debt from the construction will then be transitioned into a traditional mortgage.

One good thing about the stand-alone construction loan is that if you only have a small amount to put towards the home as a down payment, but you also own a home that you plan to sell later, you will be able to use that money towards your down payment after your current home has been sold. The key issue, however, is that locking in a mortgage rate is not an option with the stand-alone loan. What that means for you is that you could potentially experience significantly higher interest rates when securing a mortgage.

The Construction-to-Permanent Loan

The construction-to-permanent loan is a combination of both the construction loan and the standard mortgage. What that means for you is that there’s no need to refinance your original loan once the construction has taken place. Nor will you need to endure another closing. The lender simply converts or transitions the construction loan into a mortgage loan once the construction has been completed.

Unlike the stand-alone construction loan, the construction-to-permanent loan allows borrowers to have the option of having an adjustable or a fixed interest rate. The terms are typically either 15 years or 30 years. It also provides the benefit of lower interest rates from the very beginning of the loan.

Although the construction-to-permanent loan is more convenient, it normally requires a larger down payment. Usually as high as 20% or more.

Typical Requirements to Qualify for a Construction Loan

Before a lender will approve a borrower for a construction loan, there are some qualifications that are required beforehand.

Income and Credit Score Requirement

For the most part, to qualify for a construction loan, the borrower needs a credit score of 680 or higher in almost all cases. Lenders tend to rely on the credit score of the borrower since there’s no existing home for them to use as collateral. In addition to that, they also require a minimum of a 20% down payment as well as proof of income and other assurances that indicates the borrower can confidently make the monthly payments. This includes the monthly interest payments that are required during the construction phase as well as the mortgage payments that are due for the life of the loan.

Requirements for the Construction Project

Lenders require detailed information about your construction project prior to approving you for the construction loan. They need details about the general contractor, the subcontractors who will be performing the work, the type of materials that will be used, the size of the house, a detailed project work schedule and a detailed budget.

Lenders need this information to evaluate the likelihood of the project being completed by qualified contractors and with the use of quality materials that will last for a lifetime. This requirement is also an effort to perform additional due diligence to ultimately minimize risk.

Additional Tips to Consider Before Building Your New Home

Shop Around: Since construction home loans are considered riskier than traditional home loans, fewer banks and financial institutions offer them. And those that do may not embrace your loan. You should also consider credit unions or small local banks.

Get Pre Approved: Although you may be anxious to get your new custom home built from the ground up, it’s best to get pre-approved for your home construction loan before you get too far in the process. Not only will this save you a lot of heartaches, but it could also save you thousands of dollars typically spent for the creation of blueprints and the design work.

When approaching the lender, let them know that you first want to get pre-approved. If for whatever reason your loan request is denied, they can let you know what you need to do to qualify for the loan.

Although this may take some time, it will certainly put you in a better position than it would if you approached the lender before knowing where you stand. This approach could save you time and money too.


We’ve provided you with information about what a construction loan is, the different types of construction loans available to you, how to obtain a construction and what they typically cover. As you continue your home building journey, please also keep in mind that lenders consider construction loans riskier than standard mortgage loans. As a result, interest rates tend to run a bit higher. But if you have good credit and a good debt-to-income ratio, you could consider negotiating the best interest rate possible. Do your homework, be patient. Then you can enjoy the best mortgage rates possible while enjoying your new home too.