Guide to Construction Loans & Financing

What Is a Construction Loan?

Building a home is an emotional journey. But when done right and with the right team to support you, it can also be very rewarding. Seeing your vision come to fruition and your dream house constructed the way you want it is a deeply satisfying feeling. Because of the emotional reward, building your own house can be a good alternative to buying.

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.

You will need strong credit and a down payment of 20% to 25%. The specific down payment requirement is determined by the cost of the land and planned construction. If you already own the land, you can use it as equity for your construction loan. Your lender will check the credit and credentials of your builder as well.

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Construction loan types

Construction-to-permanent loans

Construction-to-permanent loans convert to a permanent mortgage when building is complete. Also known as "single-close" construction loans, interest rates are locked in at closing. These loans are best if you have a straightforward construction plan and want predictable interest rates.

Construction-only loans

Construction-only loans, also known as "two-close" construction loans, must be paid off when the building is complete. The loans require the borrower to qualify, get approved and pay closing costs multiple times. Construction-only loans are an option if you have large cash reserves or want to shop for a permanent lender during the building phase.

Renovation construction loans

With renovation construction loans, the cost of major renovations are wrapped into the mortgage instead of financed after closing. The loan is based on the home’s value after repairs and renovations. These loans make sense if you are buying a fixer-upper but don't have cash for renovations.

What does a construction loan cover?

Every project is different, but in general, a construction loan pays for:

• Land.

• Plans, permits and fees.

• Labor and materials.

• Closing costs.

• Contingency reserves (in case the project costs more than estimated).

• Interest reserves (if you don’t want to make interest payments during building).