Home Construction Loans: What to Know

Financing new construction has a specific rule book. Here is an introduction to the fiscal side of building a home from the ground up.

You are searching for the perfect plot of land, the perfect plan and the perfect contractor so you can move forward on building the custom home you’ve been dreaming of. Before you finalize all those details, though, there is another important task to take care of — lining up financing.

Even if you’ve been through the financing process before, construction loans have a unique set of rules and requirements, and they are not one-size-fits all. You must fill out an application, meet certain minimum qualifications and agree to regular payment due dates for the duration of the loan.

Before you approach your lender, it’s important to familiarize yourself with how construction loans work so you aren’t caught off guard by all the regulations and procedures.

DIYers Need Not Apply

One of the most important pieces of information to know before starting the construction loan process may disappoint those who wish to do most of the work themselves. If you get a construction loan, you must have a professional general contractor oversee the construction.

“Sweat equity is not allowed,” says Denver-based mortgage broker Chris Roberts. “You cannot do the work (yourself) … and if you are caught on the property doing work they can cancel the whole loan.”

The only exception would be for those with credentials to act as their general contractor. In this case, you would apply for what is referred to as an owner-builder loan. And yes, you are going to have to prove to your lender that you are legitimately qualified, Roberts says.

Types of Construction Loans

Everyone, owner-builder or not, has two options with construction loans.

The first, and most straightforward, is called a construction-to-permanent loan. Also known as a one-time close loan, this type of construction loan is an all-in-one transaction. You fill out one application and pay closing costs just one time. The loan provides the funds to build your home. When the build is complete, the loan transitions into your permanent mortgage.

The other option is a construction-only loan. Just as the name implies, this loan is for the building process only. Once the build is complete, you’ll need to apply for and obtain a regular mortgage (usually, there is a one-year time limit). While this creates extra work and ultimately requires additional closing costs, it also gives you flexibility. If you’re not happy with the rate or terms on your construction loan, you can shop around for a more appealing permanent mortgage later.

Where Do I Apply for a Construction Loan?

Construction loans are typically obtained via the same channels used to obtain any other type of mortgage — mortgage brokers, banks and credit unions. Not all lenders offer construction loans, though, so you’ll need to shop around. In some case, even if they don’t offer construction loans, they will refinance construction-only loans into permanent mortgages.

If you are interested in a Federal Housing Administration (FHA) loan, a Department of Veterans Affairs (VA) loan or a U.S. Department of Agriculture (USDA) loan, no worries. All these programs offer construction loans.

Rates and Qualifications for Construction Loans

Qualifying for a construction loan is like qualifying for a traditional mortgage. You’ll typically need a down payment of at least 20 percent and proof you meet the minimum income and debt-to-income requirements set forth by your lender. (Down payment requirements might be different for FHA, VA and USDA loans.) You’ll also need an acceptable credit score, with the definition of “acceptable” depending on the lender.

As for interest rates, they vary based on the lender and the applicant’s qualifications. However, Roberts says rates are usually competitive and similar to traditional mortgage rates, at least for construction-to-permanent loans. Rates for construction-only loans are sometimes slightly higher, he says. Again, terms vary, but in many cases payments during the construction phase of your project will be interest-only.

What Do My Home Construction Loan Funds Cover?

You can use your construction loan to buy land and pay your building-related expenses. That includes your general contractor and subcontractors, all of your materials, plans, permits and closing costs. However, you’ll need to find another way to pay for your appliances, window coverings and furniture because only permanent fixtures are considered qualified expenses.

Dawn Weinberger
Dawn Weinberger is a freelance writer in Portland, Oregon who has contributed to numerous publications and websites over the past 20 years, including RD.com, Glamour, Women's Health, Entrepreneur, and many others. Dawn has a BA in journalism from Western Washington University and is a member of the American Society of Journalists and Authors. She writes about everything from health and medicine to fashion, shopping, and business.