How Do Construction Loans Work?

Buying a house is not a small decision, but when building a house, the deposit is even higher. Between finding the right contracting company, meeting building codes, and determining your mortgage payments, building your home can quickly become a daunting task. A construction loan – essentially a lump sum you receive to finance your construction costs – can help you manage the financial aspects of this undertaking.

What is a construction loan?

When you buy a home, you secure a mortgage. But when you build a home, you’ll likely have to take out a more specific type of loan called a construction loan. Unlike mortgage loans, which typically have a term of 30 years, construction loans have a shorter term. Because they are considered a financial risk to the lender, they usually carry a higher interest rate.

For construction loans, the lender pays the building contractor directly instead of giving the money to the homeowner. These payments are made in periodic stages throughout the construction process. They usually come when developers have met certain observable standards. Once the builders have completed the house, the homeowner will usually pay off the loan in full. Otherwise, the loan will be converted to a permanent mortgage on the borrower.

Different types of construction loans

As with conventional mortgage loans, one size does not fit all construction loans. There are three main types of construction loans you may encounter:

  • Construction loan to forever
  • Independent construction loan
  • Loan for construction and renovation

In a construction-to-permanent loan (also known as a one-time closing loan), you borrow money to pay for the construction of the house itself. When you move into your new home, the loan automatically becomes a mortgage. At the time of closing, you will fix your interest rate. For individuals who plan to build their own solid home, a one-time closing loan will offer the same fixed interest rate and no possibility of fluctuations.

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The next major category, standalone construction loans (also known as “double closing”), are essentially two separate loans. Basically, your first loan will pay for the construction. After completing the house and preparing to move in, you will be mortgaged. That second loan is to pay off the debt you incurred from the construction. Standalone construction loans are right for you if you have substantial cash on hand. Ditto if you did not set up a relationship with the lender at the time of the start of construction.

The third major type of construction loan is called a renovation construction loan. With a renovation loan from a trusted lender, individuals can pack the cost of the entire construction and renovation into the final mortgage. The expected value of the home after repairs and renovations will determine the size of the loan. This is primarily for individuals who want to buy a home in need of major repairs. We often refer to these homes as “homebuilders”.

What do construction loans include?

Construction loans can be of great help to any individual or family looking to build their dream home, instead of buying an existing model. Even so, construction loans cover a multitude of different home ownership initiatives.

Most notably, this list includes the purchase price of the plot of land on which you intend to build a home and the closing costs of the transaction. Additionally, many lenders will include a provision that provides funds for so-called “soft costs” such as house plan design fees, mechanical engineering, and work permits and land.

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Construction loans cover a wide range of costs. They can be applied to a variety of home buying and remodeling needs, and they cater to first-time home builders. So they can be an attractive option for your own project.

The main difference between the types of construction loans stems from whether the borrower is building a new home or renovating an older one. In the case of new construction, your lender will want to make sure you’re in a financially sound place and that you have a specific and workable plan for your home.

Once your lender considers you a viable candidate, they will offer a construction loan. You receive recurring installments as the construction of your home takes shape. If you’re inclined to pay for repairs, the loan will count toward your permanent mortgage instead.

Conclusion

Simply put, construction loans work by allowing first-time home builders to have enough credit to carry out their project plans. As always, the relationship between lenders and borrowers is key. Communication from lenders, borrowers and builders is paramount.

As with any loan, carefully consider the terms of the loan and its impact on your finances. You should also work with a financial advisor to see how it fits into your financial plan.

Tips for managing your finances

  • If you’re interested in getting a construction loan, but aren’t sure if your current finances allow it, get the answers you need from a financial advisor. Fortunately, finding the right advisor to suit your needs is not difficult. SmartAsset’s free tool will help you connect with financial advisors in your area in 5 minutes. If you are ready to be matched with local advisors who will help you achieve your financial goals, get started now.
  • Building your dream home can be an incredible experience, but if you’re not careful, it can also go bankrupt. Be proactive and before you build, set up a savings account. This way, you can set aside funds in case of unexpected needs.
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Image credits: © iStock.com/skynesher, © iStock.com/skynesher, © iStock.com/skynesher

Jane Thier Jane Thier writes on a variety of personal finance topics for SmartAsset. Her expertise includes banking and mortgages. Jane is currently studying at Washington University in St. Louis and is the editor-in-chief of Armor Magazine. Jane aims to receive a Master’s degree in Journalism.

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