What are construction loans and how do they work?



Are you thinking about making one of the largest purchases of your life on something that doesn’t even exist yet? It happens all the time when you plan to purchase a new construction home. The benefits to this though can be huge, especially if you’re a fan of customization. So, what’s the cost of buying a new construction home, and what’s involved?

You might be surprised to find out that getting a mortgage for a new construction home is quite different than borrowing money to purchase one that already exists. So, is a new construction loan right for you? Here’s a few things to know if you’re considering one.

First, what is a “construction loan”?

A construction loan will provide you with the funds that are needed to build a residential property (meaning your new home!). They are typically good for one year, meaning that the property is expected to be built in that timeframe. After that time, you may be asked to show a certificate of occupancy to ensure that construction is complete, and you are living in your new residence.

Okay, enough dictionary talk on what a construction loan is; let’s get more into how they work, and what you should expect during construction if you opt for one.

The cost

So, first, let’s talk more about money. A construction loan will often have a higher interest rate than a conventional mortgage loan. Don’t be alarmed, though – this is usually only for a temporary amount of time, and you’ll only make payments on the interest. Here’s how it works.

When you’re approved by your lender, they’ll make various installments of money as the construction on your home progresses. These payments often occur after major milestones are completed (like when your home’s foundation is laid, or the house framing begins). The lender keeps their eye on their investment (your future home) by sending an appraiser or inspector to your future property to check on the various stages of construction. This happens about six times throughout the construction of your home. When the appraiser or inspector reports back with an all-okay to your lender, the lender releases payment to your contractor. In turn, you’ll be expected to make interest-only payments to your lender for these installments of money, until the completion of your home. So, why a higher interest rate?

That’s because in a traditional transaction of purchasing an existing home, you will be using that home as collateral. When you’re asking a lender to give you money for a home that does not yet exist, they are taking on a bigger risk and therefore, charge a higher rate. The lender will want to see the builder’s timeline for completion of the project, plans for the property and the budget as, we mentioned above.

Transitioning from a new construction loan to a traditional one

We mentioned the higher interest rate for a “temporary amount of time” because a construction loan will often last up to one year. Then, you may be able to convert your new construction loan to a conventional mortgage once all construction is complete. This is called a construction-to-permanent loan. If the loan you were approved for by your lender was only to cover the construction phase of your home, then you may have to get a separate mortgage that’s designed to pay off your construction loan, which acts similarly to a traditional mortgage.

What does a construction loan cover?

The list of what a construction loan covers is short and sweet but oh-so important. This loan type will be used to cover:

  • The cost of the land your new property is being built on
  • The contractor’s labor costs
  • Building materials
  • Permits needed to complete the project

Two most common types of construction loans

  1. Construction-to-permanent loan: Lets you borrow money to pay for the cost of building your home. Once you move in, the loan is converted to a permanent mortgage. A benefit here is that you only have to pay closing costs once, reducing your overall fees.
  2. Construction-only loan: Provides the funds necessary to complete the building of the home, but you’re responsible for paying the loan in full after completion of construction, or for getting a mortgage to pay off the rest over time.

Construction loan requirements

Lenders want to see the following before approving you for a new construction loan. You’ll need to have:

  • A credit score in good standing
  • A low debt-to-income ratio
  • Proof that you can repay that loan
  • A loan down payment (often, this is 3% of the home’s total cost)
  • A detailed plan of repayment once construction is complete (this may be provided to you by the builder)

How to get a construction loan

The process of getting a construction loan from a lender is a little different than getting a conventional, FHA, or other more common type of mortgage. Here’s the process broken down into three simple steps:

  1. Find a licensed builder:Ask friends for recommendations, and do your research online when comparing builders. Are they in good standing with your state’s Construction Contractor’s Board?
  2. Get your documents together:You’ll need to obtain a contract from your builder. It should include pricing and plans for the new construction home that you want to purchase.
  3. Get pre-approved:Find the right lender who will pre-approve you for a construction loan, so you’ll know how much money you can borrow for the completion of the project.

Consider these additional tips to go above and beyond what you need to do to get approved for a construction loan. They’ll help you consider if this is the right situation for you.

Tip 1: Be aware of new construction timing

They say timing is everything for a reason. When you’re seriously considering purchasing a new construction home, you need to consider what can cause delays. This could include unpredictable situations like vendor delays, material shortages, permit approvals or simply weather delays. Many new construction homes can take six months, or up to a year to complete the build. if you have a lot of flexibility with timing, this may be no problem for you. But, if you are working within a certain timeline, you may have to pass.

Get a guarantee in writing by the builder for a completion date, especially since you may have to make living arrangements until your new home is built.

Tip 2: Research the neighborhood

Don’t forget – this isn’t just a home you’re going to look at; you’re going to live there too! Consider the details of the neighborhood and how they may affect your quality of life. Is this the right builder and neighborhood for you?

Do your research and keep these points in mind:

  • Read online reviews from other’s who live in this builder’s previous communities (or the current one you’re looking at, if available).
  • Find out if the builder is in good standing with your state’s Construction Contractor’s Board.
  • Take a drive or a walk around the neighborhood at different times of the day.
  • Talk with residents who live there.
  • Go to model home open houses and take notes!

Ask you developer about any Homeowner’s Association (HOA) fees, and what rules they may have in place for the community. For example, if you have a big family or own a lot of cars and want to park on the street at times, is that allowed? Can you take the garbage out to the curb the night before, or is that against HOA rules? Are sheds allowed? Find out what they are to make sure they don’t cause any headaches for you later.

Tip 3: Understand what your home warranty covers

Did you know that state law will often require a certain warranty for new construction homes, and many builders will offer additional converge through a home warranty on top of that? It may be offered through a third party, if not from the builder directly, and coverage will vary from builder to builder. But, you may be able to negotiate this into your deal, or add additional provisions that the warranty that would not normally be covered.

Tip 4: Remember, you’re purchasing a new home not the model

When you’re walking through a builder’s model home, the best thing to keep in mind is what will come with your home. The model that builders like to show will include upgrades and special amenities, so it’s important to find out what comes with the base home price. Gaining an understanding of what your model will or won’t include will help you make the decision to opt for upgrades or wait to include those down the road.

The bottom line

Were we able to shed some light on the construction loan process and help you decide if a new build is right for you? You’ll be more involved in the process than if you were to make a traditional home purchase, but everything will be new and shiny, which could make the waiting time worth it. Do your research on the community being built around you, make realistic decisions on finishes and appliances that fit your lifestyle, and plan to do a final walk-through on your home prior to closing. If you’re in the market to get a new construction home loan, Homespire can help.



This is not an offer for a loan or any type of extension. Eligibility for a loan or extension of credit from Homespire Mortgage Corporation is subject to completion of a loan application, credit, income, and employment qualification, and meeting established underwriting criteria. Rates are subject to change without notice based on market conditions. See Loan Consultant for information on program income limits, buyer contribution, area median income, debt requirements, and other application details.