What are construction loans?
Construction loans are loans that fund the building of a residential home (aka a stick-built house), from the land purchase to the finished structure. Common types are a standalone construction loan — a short-term loan (generally with a year-long term) — which only finances the building phase, and a construction-to-permanent loan, which converts into a mortgage once the construction is done. Borrowers who take out a standalone construction loan often get a separate mortgage to pay it off when the principal falls due.
What cost are covered by a construction loan?
- The Land/Lot
- Contractor Labor
- Building Materials
- Permits
Types Of Construction Loans
Different construction loan types are available to borrowers and are designed to suit various financial needs.
Construction-to-permanent loan
With a construction-to-permanent loan, once the house is complete and you move in, the loan morphs into a traditional mortgage. Typically, you can choose your term of 15 to 30 years, and you can opt for a fixed rate or an adjustable rate.
During the construction-loan phase, you’re only responsible for interest payments on the money drawn, as it’s drawn. After the conversion, you start making payments that cover interest and the principal — as you would with any mortgage.
While many construction loans are conventional loans — entirely privately originated and financed — there are government versions as well. Your other options include an FHA construction-to-permanent loan — with less stringent approval standards that can be especially helpful for some borrowers — or a VA construction loan if you’re an eligible veteran.
Whatever the type, the big benefit of the construction-to-permanent approach is that you have only a single set of closing costs to pay, reducing your overall expenses. “There’s a one-time closing, so you don’t pay duplicate settlement fees,” says Janet Bossi, senior vice president at OceanFirst Bank in New Jersey. Different construction loan types are available to borrowers and are designed to suit various financial needs.
Construction-only loan
A construction-only loan provides the funds necessary to build the property but the borrower is responsible for repaying the loan in full at maturity (typically one year or less). You can settle the debt in cash or by obtaining a mortgage to pay it off.
The advantage of this approach: You might get better terms with the new mortgage (construction loans tend to be more expensive – see “Construction loan rates” below). Still, construction-only loans can ultimately be costlier than their construction-to-permanent cousins. That’s because you complete two separate loan transactions and pay two sets of closing costs (which tend to equal thousands of dollars). And, of course, you have to invest time and energy shopping for a mortgage.
Another consideration: If your financial situation worsens during the building, you might not be able to qualify for a mortgage later on — and might not be able to move into your new house.
Renovation Loan
If you want to upgrade an existing property rather than build one, you can compare home renovation loan options. These come in a variety of forms depending on the amount of money you’re spending on the project. Another viable option in a low mortgage rate environment is a cash-out refinance, in which a homeowner takes out a new mortgage in a higher amount than their current loan, receiving the extra as a lump sum. As rates tick up, though, cash-out refis become less appealing.
With refis, the lender generally does not require disclosure of how the funds will be used. The borrower manages the budget, the plan and the payments. With some renovation loans, the lender will evaluate the builder, review the budget and oversee the draw schedule.