Construction Loans: How They Work and How To Qualify

Borrowing to build or rehabilitate a home with a construction mortgage can be appealing if you want to design your dream home or just can't find an available property that checks all the right boxes. However, construction mortgages may have more stringent credit requirements and higher interest rates than traditional mortgages because the lender assumes more risk, as there's no finished house to guarantee the loan. 

This guide explains how construction loans work, including their qualification requirements and complex payment structure.

What is a construction loan?

A construction loan is a short-term loan used to finance the costs of building or rebuilding a home. Borrowed money is released in installments corresponding with different phases of the construction process, and interest-only payments for six to up to 24 months aren’t uncommon.

Some construction loans convert into standard mortgages secured by the finished property once the construction process is complete. Others require the borrower to pay a lump sum at the end of the term, usually by taking out a new mortgage to repay the balance. 

What do construction loans cover?

Construction loans cover costs associated with building or rehabilitating a home. Depending on how the loan is structured, the covered costs may include:

• Acquisition of land
• Building materials
• Contractor wages
• Building permits and other development fees

How do construction loans work?

Standard 30-year fixed-rate mortgages are secured by existing homes, and borrowers often choose fixed-rate mortgages so that their monthly payments stay the same for the life of the loan. Construction loans work differently. 

“Construction lenders will often use a third-party escrow to release the loan proceeds as the work is completed,” explains Darren K. Proulx, a Nevada mortgage broker and strategic financing advisor at Real Estate Bees. “For example, when the concrete foundation is completed, the funds for that item are released directly to the concrete contractor.”

Typically, your lender approves a total loan amount and releases funds in stages. You submit a draw request when you're ready to make a payment to your builder. Your lender releases the funds for each phase of the project after a site inspection.

During this process, borrowers typically make interest-only payments and only on the amount of funds that have actually been released. Once your home is completed, you may be able to convert your short-term construction loan into a standard 30-year mortgage, or you must pay off the full balance of the loan, usually by taking out a traditional mortgage to cover the cost. 

Types of construction loans

Construction-to-permanent loans

With a construction-to-permanent loan, you make only interest payments to the lender during the construction phase, and the short-term loan converts to a traditional mortgage when building is complete. Then you begin making principal and interest payments. Since you don't have to get a new loan, you may be able to lock in your final mortgage rate before construction begins and pay just one set of closing costs.

Construction-to-permanent loans tend to have higher interest rates than traditional mortgages. Still, the benefits may outweigh the drawbacks for homebuyers who will live in their home after construction is finished. 

“A single closing reduces closing costs for the borrower and gives them certainty on their final mortgage interest rate. This is valuable peace of mind in a volatile rate environment,” says Tyler Baldocchi, director of product development at Planet Home Lending. 

Stand-alone construction loans

A stand-alone construction loan is a short-term loan with interest-only payments that you must repay in full when construction is complete. Stand-alone construction loans may be best for “fix-and-flip” real estate investors who intend to resell the finished home. 

Owner-builder construction loans

Owner-builder construction loans allow the buyer to act as the contractor. Homeowners with construction experience or a contractor’s license may be eligible, although some lenders may approve non-licensed borrowers who are otherwise well qualified. Lenders typically charge higher interest rates and require larger down payments to account for the added risk. 

“Owner-builder loans are wonderful as they provide a way for the borrower to create equity by acting as the contractor on the job,” Proulx says. These loans are best for borrowers with significant construction experience. 

If you’ve never built a house before, an owner-builder loan is risky. You could underestimate the cost or projected timeline and end up buried in high-cost debt without a finished place to live. 

Renovation construction loans

Renovation construction loans finance the cost of acquiring and remodeling or repairing a home. These loans may be best for homeowners looking to purchase a fixer-upper. 

FHA 203(k) loans

203(k) loans are loans insured by the Federal Housing Administration (FHA) that cover the purchase or refinance and rehabilitation of an existing property. 

These loans offer benefits such as down payments as low as 3.5%, more relaxed credit requirements than other construction loans, and a single set of closing costs. But they’re only available to owner-occupants. FHA 203(k) loans are best for people looking to purchase a fixer-upper that they intend to live in for at least a year. 

What are the requirements for a construction loan?

Underwriting criteria for construction loans are stricter compared to traditional mortgage qualification requirements. 

“With a traditional mortgage, the home is standing and the collateral is visible,” says Michael Brennan, president at Nationwide Mortgage Bankers. “Underwriting focuses primarily on the borrower’s income, credit profile, and the property’s appraised value. Construction loans require deeper analysis because the collateral is still being created.”

While requirements vary by lender and loan type, most construction lenders typically look for:

• Detailed construction project plans
• Project timelines and budgets
• Zoning and building permits
• A contract with a licensed and insured builder 
• An appraisal for the value of the finished home
• A good credit score (generally a FICO score of 670 or higher, although individual lender requirements vary)
• A 20% to 25% down payment
• A low debt-to-income ratio

Finding a reputable builder can help you get approved. “Lenders also review the builder’s track record because coordinating subcontractors, inspections, and supply deliveries requires experience,” says Brennan. 

How much down payment is required for a construction loan?

Down payment requirements for construction loans vary by lender and loan type, but tend to be high. Minimum down payments of 20%-30% of the finished appraised value are common, while conventional mortgage loans are available with as little as 3% down. 

That said, some banks allow higher loan-to-value ratios. For example, Old National Bank and Fifth Third Bank require as little as 10% down for some construction loans, and government-backed loan programs require even less. The FHA 203(k) loan program allows as little as 3.5% down for borrowers with a credit score above 580. Veterans Administration (VA) construction loans may not require any money down, although these loans are less widely available and subject to strict eligibility requirements.

What are construction loan rates and fees?

Rates and fees vary for construction loans, but must be disclosed by lenders up front under the Truth in Lending Act (TILA) and the Real Estate Settlement Procedures Act (RESPA). 

Interest is the cost of borrowing, and your interest rate is expressed as a percentage of the loan amount. Lenders are required to disclose a loan's annual percentage rate (APR), which provides a more comprehensive measure of total borrowing costs since it accounts for both the interest rate and certain upfront fees. Construction loans typically have higher interest rates than traditional mortgages, and construction-to-permanent loans usually have two different rates: an initial interest rate during the construction phase and a second rate for the permanent phase. 

Other costs can include:

• Closing costs: As with a traditional mortgage, you’ll pay closing costs such as underwriting and appraisal fees, title services, and taxes. 
• Inspection and draw fees: Your lender will charge you for site inspections and the costs of disbursing funds to your contractor. 
• Contingency reserves: Construction loan contracts usually contain a buffer for unplanned expenses or change orders. For example, the contract may set aside 10% of available funds for problems during the construction process. 
• Loan extension fees: If unforeseen circumstances delay the project beyond your original timeline, you may need to pay fees associated with a loan modification and extension agreement. “Contracts vary in how they handle unforeseen costs and delay surcharges, and those costs can be substantial,” says Baldocchi. That makes it crucial to choose the right lender. 

How do construction loans compare to traditional mortgages?

Here's a look at how typical features of construction loans and mortgages compare:

How to apply for a construction loan

Here's a list of step-by-step instructions to prepare for, apply for, and use a construction loan:

1. Find land: A real estate agent can help you find a plot of land zoned for residential housing and suitable for development. 
2. Pre-approval: Pre-approval from a construction lender gives you an idea of what you can afford before you start planning your project. Consider shopping around and checking rates and terms to find the most affordable loan. You can use an online mortgage marketplace to prequalify without affecting your credit score. 
3. Choose a builder: Work with a licensed, insured builder who has a track record of successful residential construction projects. 
4. Finalize plans: Work with an architect to finalize your blueprint, agree on a budget and timeline with your contractor, and carefully review the terms of the building contract. 
5. Gather documents: Obtain all necessary zoning and building permits, your builder’s plans and credentials, your building contract and timeline, and your personal financial documents. 
6. Apply: Submit your construction loan application, which typically requires a hard credit inquiry that can temporarily lower your credit score.
7. Underwriting: Underwriting takes several weeks. During this process, the lender evaluates your project plan to determine whether your budget is realistic. You may receive conditional approval before a scheduled appraisal. 
8. Finalize the loan: Once everything is approved, you'll sign the paperwork, pay closing costs, and receive the first distribution of funds to get the project started. 
9. Draw process: During construction, you’ll request payment from your lender in installments. An inspector will ensure the work is completed and on budget before releasing funds.

Pros and cons of construction loans

Pros

• Customization options: A construction loan gives you the opportunity to customize your home to your aesthetic and needs.
• Multi-purpose funding: One loan can cover land, permits, labor, and building materials.
• Interest-only payments: Lower payments during the construction phase give you more wiggle room. 
• Several financing options: Construction financing isn’t one-size-fits-all. You have options, including construction-to-permanent loans and FHA 203(k) loans. 
• Build with energy efficiency in mind: You can prioritize energy efficiency when constructing your home, reducing environmental impact and setting the stage for lower energy bills once the home is complete. 

Cons

• Strict underwriting standards: With the exception of some government-backed loan programs, construction loans generally have more stringent eligibility criteria.
• Interest rates may be higher than mortgages: Interest rates may be higher on construction loans. Rates may be variable as well, meaning the size of your payments can fluctuate. 
• Balloon payment: Some construction loan contracts end with a balloon payment or lump sum payment due at completion. If your loan doesn’t convert to permanent financing and your financial situation changes, you may struggle to qualify for an affordable new loan. 
• Additional living expenses: You may have to pay for rental housing while you’re building or renovating your new home. 
• Unexpected problems and delays can increase costs: Labor and material shortages or other problems can cause you to go over-budget.