What is a construction loan and how does it work?

To get a construction loan, you'll likely need a 680 credit score. Peter Cade/Getty Images

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• If you need financing to build your own home, you'll get a short-term construction loan.
• You'll likely only pay interest on the loan until construction is completed, not the principal.
• You can get a loan that converts your loan into a regular mortgage when building is finished.

When you need financing to buy a home, you get a mortgage. But what if you're building your own home, or making significant changes to a home you're buying? Then you'll need a separate type of loan called a construction loan. 

What is a construction loan?

Construction loans are short-term loans used to fund the building of a home.

While mortgages can come with terms of around 30 years, construction loans terms are usually around a year. The lender charges an adjustable rate that is higher than what you'd pay on a regular mortgage.

Construction loans are risky for lenders, because there's no existing home yet for you to put up as collateral — that's why they charge higher rates.

How do construction loans work?

When you apply for a construction loan, you'll give the lender your project timeline. The lender gives money to the builder, not to you, in installments for each stage of the building process according to your timeline. You'll probably hear the lender refer to these payment installments as "draws." An inspector or appraiser will need to evaluate the construction before each draw is approved.

Most lenders only require you to pay interest on the loan until construction is complete. The next step depends on which type of construction loan you get.

What do construction loans cover?

Unlike a mortgage, a construction loan only covers costs associated with building the house, including the following:

• Permits
• Building materials
• Labor
• Contingency reserves, or an extra chunk of money in case you think of something you want to add to your plan after you've started the building process

Types of construction loans

Construction-to-permanent loan

With a construction-to-permanent loan, you'll roll the construction loan into a regular mortgage once the building is complete.

You'll probably only pay interest during the construction period, and it will be an adjustable-rate loan. You still will not have paid off the money you initially borrowed, or the principal, by the time construction ends. You'll roll the principal into your regular mortgage and choose between an adjustable-rate or fixed-rate mortgage. Then you'll start making monthly payments that include the principal.

If you choose a construction-to-permanent loan, you only have to apply for one loan, and you'll only pay one set of closing fees.

Construction-only loan

With a construction-only loan, you get a construction loan without converting it into a regular mortgage later.

Your lender will probably only require you to pay interest during the building period. Once construction is complete, you'll pay off the principal in one lump sum. This could be a worthwhile option if you have savings set aside to pay off the construction loan all at once, or if you plan to get a separate mortgage to pay off the loan.

Not all lenders offer construction-to-permanent loans. So if you know you want to use a certain lender but it doesn't have construction-to-permanent loans, you might choose a construction-only loan.

This type of loan does have its drawbacks, though. Because you have to get a mortgage separately from your construction loan, you'll have to go through the application and approval processes more than once. You'll also have to pay two sets of closing costs.

End loan

End loans go hand-in-hand with construction-only loans. The end loan refers to the long-term, permanent mortgage that replaces your construction-only loan once the house is completed.

Remember that the end loan is separate from the construction loan, meaning you'll go through two closings: one for the construction loan, and one for your permanent mortgage.

Owner-builder construction loan

You'll apply for an owner-builder construction loan if you, the borrower, are the one doing the construction. Many lenders don't approve this type of loan. If you want to build the home yourself, you'll need to have a license and work in construction for a living to be approved.

Renovation loan

You might want a renovation loan if you're buying a home that already exists, but you want to make significant changes, like adding another room. Renovation costs are wrapped up in the mortgage, so you only have to apply for one loan and pay closing costs one time.

You may choose a different type of loan to cover home renovations, such as a personal loan. The best choice will depend on your situation, but know that a renovation loan typically comes with a lower interest rate than personal loans. The lender will also be much more involved in the renovation process than it would be if you chose another type of loan, because the lender needs to know your timeline and what you plan to spend the money on.

What are construction loan rates?

Construction loan rates are adjustable, meaning your rate will fluctuate according to the index it's tied to (such as the prime rate).

Construction loan rates are typically higher than mortgage rates. This is because mortgages use the home as collateral, which makes the loan less risky for the lender. But with construction loans, the home hasn't been built yet, so there's no collateral to collect if the borrower isn't able to pay back the loan.

Who qualifies for a construction loan

First things first — before you even apply for a construction loan, have an in-depth meeting with your builder about your budget, timeline, and necessary permits. 

When you apply, the lender takes a deep dive into your plans, finances, and builder. Construction loans are risky for lenders, so they examine these factors thoroughly.

Your approval could partly depend on your builder. Be sure to choose a builder who has a credible work history and is known to finish projects on time. If you submit a timeline to your lender only for the company to find out your builder has a reputation for finishing projects late, this could be to your detriment.

As with a regular mortgage, a lender will look at certain aspects of your financial profile to determine whether it will lend you money. Exact eligibility requirements will vary by lender, but you'll probably need the following:

• Credit score: 680 or higher
• Debt-to-income ratio: 45% or lower
• Down payment: Minimum 20% for a construction-to-permanent or construction-only loan, although some lenders require more. For a renovation loan, you can probably put down much less. For example, if you get a 203(k) Rehab Mortgage from the FHA, you'll only need a 3.5% down payment.

Choosing a construction loan lender

Finding a lender that offers the type of loan you need may take some effort. Not all mortgage lenders offer construction loans, and of those that do, not all have construction-to-permanent loans. If you're doing the actual construction yourself and need an owner-builder construction loan, your choices will be even more limited.

Find lenders that will accept your credit score, debt-to-income ratio, and down payment. Then apply for pre-qualification or pre-approval at your top choices to compare interest rates. Finally, ask for an itemized list of fees to see whether a few lenders offering similar rates have drastically different fees.

By choosing the lender and type of construction loan that fit your situation, you'll be a couple of steps closer to building your dream home.