Home Construction Loans 101

By Melissa Green | Citizens Bank Staff

Thinking about building your dream home? A home construction loan may be a good option for you. But before you break ground, there are a lot of things you’ll need to consider. The truth is that construction loans aren’t for everyone; some have different qualification and repayment requirements than a traditional mortgage. So it’s important to understand what you’re getting into — before you get into it.

Read on to learn everything you’ve ever wanted to know about home construction loans and if they’re right for your situation.

What is a home construction loan?

A home construction loan covers the cost of building a new home — or, sometimes, major renovations to an existing house — and the land the home sits on. The terms and mechanics of the loan will depend on the type of construction loan you choose.

There are different types of construction loans for aspiring homeowners, but the most common are construction-to-permanent loans (C2P) and end loans.

Construction-to-permanent (C2P): This is a combination of traditional mortgage financing and construction financing. It’s used most frequently for custom home building where you’re not necessarily choosing from a set design plan. When construction on your home is complete, your loan will be converted into a traditional mortgage. With a C2P loan, you’ll only pay closing costs once.

End loan:  This is a more traditional mortgage where the builder finances the construction of a new home and you would use a mortgage to buy directly from the builder. This typically happens in planned communities or subdivisions. Any custom home features are generally negotiated as part of the sale and delivered by the builder before closing.

Renovation loan: If you have a fixer-upper or plans for building an addition, you could borrow against the expected value of your renovated home. Keep in mind that, depending on the scope of your project, there are alternative ways to pay for home renovations, including a home equity line of credit (HELOC), a personal loan, or a home equity loan.

Construction-only loan: A less popular way to finance your project is by taking out two separate loans: one for the construction costs and another to finance the remaining balance. A construction-only loan is short term, so when construction is finished (usually 12-18 months) you'll have a large balloon payment due. This is where the second loan would come into play. Since you have two loans, you’ll be paying two sets of closing costs.

Construction-only loans are the least common type of mortgage in today’s market. In fact, most lenders no longer offer them at all.

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How do I get a home construction loan?

Applying for a home construction loan is typically more involved than applying for a traditional mortgage. With a traditional mortgage, your home acts as collateral; if you default on your payments, the bank can take your home. Since your home isn’t built yet with a construction loan, the bank doesn’t have that leverage. In order to offset that risk, lenders tend to have additional requirements for construction loans. Every lender will have different rules, but in general, you’ll likely need:

• 20% down payment
• Strong credit score
• Low debt-to-income ratio
• Significant savings or contingency fund
• Licensed builder or contractor
• Construction plans, specifications, and schedule
• Signed contract with a builder

In addition to your financial and credit profiles, the lender will want detailed information about the lot, planned house size, materials used, and what contractors will be working on the home. If you’re working with a reputable contractor, they can make gathering this information and navigating through the process a lot easier.

How does a home construction loan work?

Once you’ve secured a C2P loan, the lender normally pays the builder through a scheduled bank draft that follows each phase of construction. At each scheduled step, the lender usually sends an inspector to check on the progress of the construction before releasing additional money.

During construction, you only make interest payments on the money you’ve taken out. Repayment of the principal loan balance begins after the home is finished and the construction loan rolls into a traditional mortgage.

Are there risks with taking out a home construction loan?

In general, construction projects don’t always run smoothly. When there are delays to the timeline, you may have to pay additional living expenses for a few months until you’re able to move in. Additionally, if your project is delayed, you may be charged a fee to extend the construction period. Vetting your builder is also an important step to help minimize risk, so it’s important to do your due diligence before making a commitment. 

Construction-only loans carry more risk than other types of mortgages. At the end of the loan term (usually 12 months), you need to be able to pay off the loan in full or secure a mortgage to pay it off. If you lose your job or your financial situation changes during construction, you may not qualify for a mortgage.

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Ready to build your dream home?

Buying or building a home is a substantial undertaking, so it’s important to be well informed and financially prepared before making any decisions. If you have questions, talk to an experienced loan officer who's ready to guide you through the process and help you decide if a home construction loan is right for you.