Construction Loans Explained: Types, Rates, and How They Work

About 1.4 million new construction homes are started or completed each year, according to the U.S. Census Bureau.² If you have your heart set on new construction, a construction loan can make your dream possible.

In this guide, learn what construction loans are, how they work, and how they compare to traditional mortgages.

What is a construction loan?

A construction loan is a short-term loan that you can use to fund the building or renovation of a home. Rather than receiving a lump sum upfront like you would with a mortgage, lenders disburse the loan in installments as each phase of construction is completed, with loan terms between six and 24 months.¹

Construction loans cover a range of building-related costs, including the land purchase, labor, building materials, and permits. Once construction ends, you'll either repay the loan in full or convert the loan into a traditional mortgage (it depends on what type of construction loan you took out).

Types of construction loans

The four main types of construction loans each come with their own requirements, disbursement structures, and best-fit borrower.

Construction-to-permanent

Best for: Buyers who want a streamlined process and plan on living in the home long-term.

A construction-to-permanent loan begins as a construction loan, then converts into a traditional mortgage once the building is complete. These loans can be converted into a conventional mortgage, Federal Housing Administration (FHA) mortgage, or Department of Veterans Affairs (VA) mortgage.

You pay the closing costs just once, which is why they're sometimes called one-time close construction loans, and you can choose between a fixed-rate or adjustable-rate mortgage.

Construction-only

Best for: Buyers who expect their finances or credit to improve by the time construction ends.

Construction-only loans cover the building phase of the home. Once construction is complete, you'll need to apply for a separate mortgage to pay off the construction loan, so there are two sets of closing costs and administrative work.

Owner-builder

Best for: Experienced contractors or builders working on their own custom homes to save on labor costs.

If you're an experienced builder or contractor, an owner-builder loan gives you the funding you need to build or renovate a property yourself. You can manage every stage of the process and customize your home, but eligibility requirements are strict, and fewer lenders offer owner-builder financing than other construction loans.

Renovation construction loans

Best for: Buyers who plan on purchasing a fixer-upper or planning a large-scale renovation.

These construction loans finance major renovations or rebuilds of existing homes, rather than new construction. They bundle purchase (or refinance) and renovation costs into a single loan, commonly through “renovation mortgages” like the FHA 203(k) Rehabilitation Mortgage Insurance Program or Fannie Mae HomeStyle Renovation loan.

Because the funds go toward improving the home itself, this type of construction loan can also improve your home’s long-term value.

Construction loans vs. mortgages

Construction loans work differently from traditional mortgages in a few key ways.

Application and approval process

Construction loans have more intensive application processes than traditional mortgages. Besides the usual financial documentation, like tax returns and pay stubs, you'll also need to provide:

• A detailed construction contract from your builder
• An itemized project budget
• An architectural construction plan and blueprint
• Building permits and zoning compliance details
• Copies of your builder's qualifications, licenses, and insurance coverage

Terms

While a traditional mortgage can have a term between 15 and 30 years, construction loans are much shorter. Typically, they have terms between six and 24 months. Construction loan rates are usually variable, meaning the rate can fluctuate over the life of the loan.

Payments

During construction, you typically make interest-only payments on the amount used so far, rather than the total loan amount. Once the construction is complete and the loan converts or is refinanced into a mortgage, you shift to making principal and interest payments.

What are the eligibility requirements for construction loans?

Lenders view construction loans as a higher risk, so they tend to come with stricter eligibility requirements than traditional mortgages:

• Credit score — In general, you'll need good to excellent credit to qualify.
• Debt-to-income ratio (DTI) — Lenders typically require a DTI under 43%.
• Down payment — Construction loans usually require a down payment of 20% of the total projected cost, depending on the lender and loan type.

Applying for a construction loan

Building a home is a major financial commitment, but a construction loan gives you the flexibility you need to create the space of your dreams. Before applying for a loan, review your budget and goals and request information from multiple lenders who offer construction financing to find the best rates and terms.

If your credit score isn’t where it needs to be for a construction loan, tools like Kikoff’s Credit Account can help. It’s free and reports your on-time payments to the major credit bureaus, helping you build the payment history lenders look for.