What is a Construction Loan? 

Written by:

Baylor Cox

Reviewed by:

• Jeremy Blaylock

Do you have a specific vision for your dream home that nothing on the market has been able to live up to? When you want a home with the exact style and layout that you have in mind, sometimes the only option is to build it yourself; in this case you’ll need a construction loan.  

A construction loan is different from a traditional mortgage, and there are several things that are important to know if you are considering getting one to build your own home from the ground up. 

How Do Construction Loans Work? 

Unlike a traditional mortgage, a construction loan is a short-term loan, usually only lasting a year or so depending on how long construction of the home is planned to take. Also, unlike a traditional mortgage, construction loan funds are not released all at once to the borrower.  

Instead, they are dispersed in what are called ‘draws’ which are based on the pre-determined draw schedule and released as construction steps are completed.  

For example, your lender will provide the funds to cover the first step in building the house, the foundation. Once completed, the lender will send out an inspector to verify that the work was completed correctly, then the funds to complete the second step are released, and so on.  

This is done to limit the risk to both the borrower and the lender by making sure the construction process goes smoothly, that the work is completed correctly, and to make sure that the funds are being used for the agreed-upon purpose. 

During the draw period, the borrower needs to make interest-only payments on the funds that have been released so far, not on the full loan amount, which keeps monthly payments low while construction is ongoing. 

Once construction is complete and the draw period ends, the loan must be paid back in full, with interest, on the full loan amount. Don’t worry, you aren’t expected to pay for it all at once out of pocket; rather, you’ll need to obtain a traditional mortgage for the home you just had built so that you can pay it back over time. 

How to Get a Construction Loan 

Obtaining a construction loan is a similar process to obtaining a mortgage. You will need several of the same documents, which you can read more about here. Qualifications for construction loans tend to be stricter compared with traditional mortgages since there is higher risk involved for the financial institution lending the funds. It is also important to note that for the same reason, construction loans tend to carry higher interest rates than traditional mortgages. 

Once you have found a qualified and licensed builder and worked with them to create thorough plans for how the construction of your new home will look, you can begin gathering the necessary documentation to apply for a mortgage. Once you have both the home plans and the mortgage documentation, you can contact your financial institution to begin the application process. 

Since there is more documentation for your financial institution to review, and more risk to them with a construction loan, the application process will likely take longer than it does with a traditional mortgage. The process is also lengthened because the financial institution will need to estimate the value of your new home once it is fully constructed, rather than performing an appraisal on an existing home. 

Using a Construction Loan for Remodeling 

Construction loans aren’t just for building new homes from scratch; they can also be used to remodel your existing home. Similarly to having a new home built from scratch, you will need to present the financial institution with detailed plans for the remodel, and the funds will be released along a draw schedule.  

A construction loan may be a good option to consider if your home needs comprehensive renovations, but it isn’t your only option. If you have enough equity in your home, you can borrow against your equity to get a HELOC or HELOAN. If you only need minor repairs or updates, a personal loan may be enough to cover them. 

Advantages and Disadvantages of Construction Loans 

If you are considering getting a construction loan, there are a number of advantages and disadvantages to consider before applying.  

Advantages 

• Ultimate customization: you can design the home of your dreams from scratch to create exactly what you want. 

• Interest-only payments during construction: For the duration of the construction process, you only have to pay interest on the funds dispersed, not on the loan principal. This lowers your monthly payments considerably. 

• Draw schedule: funds being released along a draw schedule helps protect both the financial institution and you from construction delays or shoddy craftsmanship.  

Disadvantages 

• Higher interest rate: since construction loans are seen as riskier by financial institutions, they carry a higher interest rate. 

• More complicated approval: you will need to provide extra documentation on top of what is required for a traditional mortgage including detailed construction plans. 

• Potentially variable costs: if construction is delayed due to poor weather or if construction costs increase unexpectedly, your home construction could end up delayed or over budget. In the event of going over budget, you may be required to cover the difference between the actual cost and the budget. 

Is a Construction Loan Right for Me? 

If you have searched for your dream home on the market and haven’t been able to find a home that you love, and if you are willing to shoulder the extra work of having a home built from the ground up, then a construction loan may be the best option for you.  

Keep in mind that the loan will likely have a higher interest rate compared to a traditional mortgage, and that if things go over budget, you may end up covering the difference. If you don’t mind that, construction loans give you absolute freedom and flexibility to build your new home exactly as you see it in your dreams!