When is a construction loan?

That said, there are several types of construction loans to choose from, and the application and approval process is more complex than for a traditional mortgage. We’ll help demystify construction loans by walking you through how they work, available types of financing and what you’ll need to qualify.

A construction loan is short-term financing that can be used to cover the costs associated with building a house, from start to finish. Construction loans may cover the costs of buying land, drafting plans, taking out permits and paying for labor and materials. You also can use a construction loan to access contingency reserves—if your project is more expensive than you planned—or interest reserves, for those who don’t want to make interest payments during construction.

Construction loans let future homeowners borrow money to purchase materials and pay for labor necessary to build a home. You also can often use this money to purchase the land you’re building on. If you already own the land, you may be able to use the property as collateral for your loan. Because construction loans generally are intended to cover the building process, they’re typically issued for a period of 12 to 18 months. That said, some loans automatically convert into a permanent mortgage once construction is complete.

Unlike traditional mortgages, construction loans aren’t secured by a completed house. For that reason, the application and approval processes for a construction loan also are more complex than for a mortgage. Your lender likely will want to inspect your architectural plans and examine your financial situation before approving you for financing. You will probably also need to provide an estimated construction timeline and budget.

After you’re approved for a construction loan, you won’t receive all of the funds as a lump sum. Instead, the lender will make payments to your builder through a series of draws—or installments—as they complete various stages of construction. In this way, construction loans act as a line of credit. Draws are scheduled based on the construction timeline, and your lender likely will send an inspector to evaluate the status of construction prior to each payment.

In most cases, you’ll only need to repay interest on funds as they are drawn—not on the entire loan amount. Depending on the lender, you also may have the option to convert your construction loan into a mortgage after construction is complete. If this is not an option, you can apply for a mortgage—or end loan—to pay off your construction loan.

Building a home is not a one-size-fits-all process. To meet the varying needs of future homeowners, there are several types of construction loans available—primarily, construction-to-permanent and construction-only loans. Owner-builders and homeowners performing extensive renovations on an existing house have separate options.

Like interest rates for other types of loans, rates on construction loans generally vary based on the borrower’s creditworthiness, the size of the loan and the loan term. What’s more, interest rates for construction loans typically are variable, meaning they adjust over the course of the loan based on an index, like the prime rate.

More specifically, rates usually hover at about one percentage point above standard mortgage rates. You may find construction loan rates between 5% and 6% today. This is because construction loans aren’t secured by a completed home and are therefore riskier than traditional mortgages.

Before you can get the financing necessary to start your construction project, you’ll need to get approved for a loan. This process is typically more rigorous than for mortgages and other loans because the loan won’t be secured—or collateralized—by a home. In addition to imposing traditional borrower standards, lenders also will need to review and approve architectural plans, an estimated construction timeline and a proposed budget.

To be approved for a construction loan, you will need:

There’s a lot to consider when choosing a construction loan lender, and it’s easy to get overwhelmed. For that reason, it can be tempting to settle for the first lender you find. You shouldn’t make this decision in haste. Make sure you choose a lender that fits your unique needs by asking these questions:

What Is a Construction Loan? A construction loan is short-term financing that can be used to cover the costs associated with building a house, from start to finish. Construction loans may cover the costs of buying land, drafting plans, taking out permits and paying for labor and materials.