What Is a Construction Loan?

A stand-alone construction loan is a short-term, adjustable-rate loan typically issued for a year. It solely covers the cost of building the property during the actual building period. Once the property is complete, the borrower must pay off the balance, either by paying in cash or refinancing. 

This may be a good solution for someone living in an existing home that intends to sell once construction is completed. It also comes with the possibility of timeline issues and the necessity for two closings (with associated closing fees.) 

Construction-to-permanent loans allow borrowers to transition from a stand-alone construction loan to a traditional fixed-rate mortgage once construction is completed. These loans benefit from a single round of application, paperwork, and closing fees.  

This loan type converts into a permanent mortgage more easily. It also allows borrowers to save on closing fees and possibly lock in a lower mortgage rate if rates are increasing. 

On most construction loans, the monthly payments during construction are interest-only and are based solely on the funds that are drawn during that period, not the full loan amount. 

Since construction loans are riskier for lenders than traditional mortgages, the qualification requirements are typically higher. Lenders will normally look for: 

• A credit score of 620 or higher, sometimes 720 or higher. 
• Lower debt-to-income ratios. 
• Strong income history. 
• Higher down payment requirements than traditional mortgages. 

In addition to strong prequalification requirements, construction loan lenders need paperwork from both the borrowers and the construction company. Here are some common documents you should expect to provide: 

• Standard mortgage loan documentation. This could include paystubs, W-2s, tax returns, statements for bank accounts, retirement account statements, etc. 
• A signed construction or purchase contract with your builder or developer. You will need to find a reputable home builder by contacting the National Association of Home Builders (NAHB). 
• Full set of plans and specs for the home to be built. 
• Budget with a cost breakdown of the project that is to be financed. 
• The contractor you choose may also have to provide qualifications to prove their competence and legitimacy, including financial statements, current license, and insurance. 

The lender makes payment directly to the builder to cover construction costs, labor, etc., as they complete each building stage. These installments are known as “draws” and are typically subject to receipt and approval of an inspection and lien update on the property. 

The builder must provide an estimate of the construction costs as well as a timeline of the project prior to loan closing, which will determine the loan amount, then during construction, funds are disbursed as work is completed.  Most lenders do not pay subcontractors directly, so it’s the builder and buyer’s responsibility to ensure that the subcontractors and suppliers are paid on time. Their legal recourse is against you, and you would need to sue the builder to recover losses in case of mishaps. 

The timing of disbursements varies depending on the lender. Some lending institutions may allow for monthly draws, while others only allow them after a certain “stage” of construction is complete. 

An inspection precedes each draw to ensure that each milestone is completed according to plan. The lender arranges the inspection. It is important to understand that most lenders do not inspect or guarantee quality of workmanship.  These inspections are typically used to simply determine what progress and line items are “substantially” complete and warrant being paid out. 

Construction projects often run into delays, especially when labor shortages, increasing material costs, and supply-chain issues are common occurrences. Therefore, most contractors, and sometimes lenders, include a contingency fund of 5 to 10% of the budgeted costs to cover any unexpected expenses. 

Contingency funds typically do not cover costs associated with upgrades or the borrowers changing their minds. They are strictly here to cover unforeseen and unavoidable budgetary issues. 

Many borrowers start their construction projects with an idea in mind but change their preferences along the way. Be aware that change orders that affect the cost to build or the completion timeline are subject to review and approval.  

The cost of these upgrades must typically be covered by the borrowers’ cash reserves. It is also best to work with a contractor familiar with the drawing process to avoid delays because of insufficient funds. 

Since construction loans can be a risky investment for lenders, they keep a close eye on the home-building process. The final draw is subject to final appraisal to confirm the value of the house is on par with the total loan value and that it was built according to the original plans and specs. Therefore, it is essential to choose an established and reliable home builder.

• The borrower typically only pays interest for the funds used during the building process. This makes the cost of building a home while renting or owning another home more manageable. 
• Construction loans provide more flexibility than traditional loans, such as personal loans. 
• Lending guidelines and frequent inspections may seem like a hassle, but they ensure that your project stays on budget and schedule. 
• You can choose a construction loan that fits your timeline and priorities. 

• Since construction loans are riskier for the lender, interest rates can be higher. 
• Qualifying requirements are stricter than most loans and mortgages. 
• There is always a share of risk associated with any loan. If issues arise during the construction process, you are still responsible for paying the balance of the loan once it expires. 
• It is your responsibility to select a qualified builder.  Since the lender is not inspecting for quality of workmanship or paying subcontractors directly, issues that arise between you and the builder may impact your mortgage loan.