Construction Loans: What to Know Before You Build a Home
Building a home gives you the chance to create a space around the way you actually live. But financing a home that's still just a set of plans is different from financing a home that's already standing.
If you're considering building a house, a construction loan can help turn those plans into a finished home. Here's what to expect, how the process works, and how construction financing differs from a typical mortgage.
What is a construction loan?
A construction loan is financing designed to cover the costs of building a new home. Instead of receiving the full loan amount at closing, funds are generally released in stages as construction progresses.
The process typically involves three moving pieces: you, your builder, and your lender. Your lender reviews the project and your finances, your builder completes the work according to the construction plans and contract, and the lender manages the funds being used to pay for the project.
Many construction loans are structured as construction-to-permanent financing, meaning the construction financing converts into a traditional long-term mortgage once your home is complete. Depending on the loan structure, this may involve one closing or two separate closings.
How is a construction loan different from a typical mortgage?
When you buy an existing home, you're generally financing a property that already exists. The purchase contract, appraisal, inspection, and closing all revolve around that finished property.
Building a home adds another layer: the property is still being created.
That means your lender may need to review things you wouldn't typically encounter when buying an existing house, including:
- Building plans and specifications
- The construction contract
- Your builder and project
- The expected construction costs
- The property's projected value when complete
- A draw schedule for construction funds
- Inspections throughout the building process
Rather than sending the entire loan amount to you or the builder at closing, construction funds are typically distributed through scheduled draws as work is completed. Inspections may be required before funds are released.
What does the construction loan process look like?
While every project is different, here's a general idea of what you can expect.
1. Get your financing lined up
It's a good idea to talk with your lender early, ideally before you've finalized your plans or signed a construction contract.
You'll go through a financial review similar to a traditional mortgage, including your income, assets, debts, credit, and available funds. Your lender can also help you understand how the construction financing and eventual permanent mortgage will work together.
2. Choose your builder and finalize the project
Your lender will typically need detailed information about the project, including your plans, specifications, construction contract, budget, and builder.
This is one reason construction financing can feel more involved than a standard home purchase. Your lender needs enough information to understand what you're building and what it is expected to cost.
3. Review the completed value
The lender will generally use an appraisal that considers the home's as-completed value, rather than the current lot.
The appraisal and loan structure help determine how much can be financed for the project. For certain construction-to-permanent transactions, Fannie Mae's guidelines calculate the loan-to-value ratio using the lesser of the total project cost or the home's as-completed appraised value.
4. Close on the loan
Once the loan is approved and the project is ready to move forward, you'll close on your construction financing.
Depending on the loan structure, construction and permanent financing may be combined into one closing, or they may involve separate closings. With a single-closing construction-to-permanent loan, the construction financing and permanent mortgage are established together, and the loan converts to its permanent terms when construction is complete.
5. Build, inspect, and draw
Now comes the part we’ve all been waiting for: construction.
Your builder completes the work according to the plans and construction schedule. As milestones are reached, the builder can request draws from the construction loan. The lender may order an inspection to confirm the work has progressed before releasing funds.*
6. Finish the home and transition to your mortgage
Once construction is complete, the lender will verify that the project has been finished and that the requirements for the permanent loan have been met.
Depending on the loan and applicable requirements, this can include a final appraisal or completion report, lien waivers, and a certificate of occupancy.
For a construction-to-permanent loan, the construction financing then converts into the permanent mortgage according to the terms of the loan.
What costs can a construction loan cover?
This depends on your lender and loan program, but construction financing can potentially cover more than just the cost of framing and finishing the house.
Depending on the project, eligible costs may include the lot, construction labor and materials, permits, and other costs directly related to building the home.
If you already own the land, your financing may be structured differently than if you're purchasing the lot as part of the construction transaction. Your lender can walk you through how your land ownership affects the loan structure.
What happens if construction costs change?
Construction budgets can change. Material costs can fluctuate, plans can evolve, and you may decide that the kitchen absolutely needs that upgrade you've been thinking about since day one.
Your construction loan is based on an approved project budget, so it’s best not to assume you can simply add costs later. Talk with your lender before making changes to the plans, contract, or budget.
It's also worth building some financial breathing room into your overall plans. Your lender can explain how your particular loan handles changes, contingencies, and potential cost overruns.
How much money do you need for a construction loan?
There's no single down payment or cash requirement that applies to every construction loan.
The amount you'll need can depend on the loan program, your credit and financial profile, the project cost, the appraised value, whether you're purchasing the lot or already own it, and other factors.
Your lender can help you determine how much you'll need to bring to the project and which funds may be eligible to be used toward the transaction.
Construction loan vs. regular mortgage: What's the difference?
The easiest way to think about it is this: A traditional mortgage finances a home. A construction loan finances the home and the process of creating it.
That extra coordination is what makes construction lending different. It can also give you more flexibility to create a home around your needs instead of trying to find the perfect home that's already on the market.
What should you ask your lender before building?
Before you commit to a builder or break ground, ask:
- How does the construction loan convert to a permanent mortgage?
- How are construction draws handled?
- What costs can be included in the loan?
- What happens if my project takes longer than expected?
- How are changes or cost overruns handled?
- What will I need to provide during construction?
- What happens if I already own the lot?
The answers can vary from one lender and loan program to another, so getting clear on the details early can help ensure the process goes smoothly.
About Luminate Bank
At Luminate Bank, we believe financing should make the path to your next chapter feel a little clearer. As an FDIC-insured bank and full-service mortgage lender, we offer a range of financing options and the expertise to help you navigate the details of building a home. Whether you're starting with a piece of land, working with a builder, or already have plans in hand, our team can help you understand your construction financing options and what comes next.
Frequently Asked Questions
Can I use a construction loan to buy the land and build the house?
Potentially, yes. Some construction-to-permanent structures can finance both the lot and construction of the home. If you already own the lot, the transaction may be structured differently.
Do construction loans have higher interest rates?
Construction loans are generally short-term financing, and the interest rate during the construction phase can be higher than the rate on a traditional long-term mortgage. The specific rate and structure depend on the lender and loan program.
Do I have to make a second down payment when construction is finished?
With a single-closing construction-to-permanent loan, the construction financing and permanent mortgage are established together, so there isn't necessarily a second traditional mortgage closing when construction ends. Two-closing structures work differently.
How long does a construction loan take?
The construction period depends on the project, builder, permits, weather, materials, and other factors. Your lender can explain the timeline and requirements for your specific loan. For certain Fannie Mae-eligible single-closing construction-to-permanent loans, the construction period cannot exceed 18 months.
Can I build a custom home with a construction loan?
Construction-to-permanent financing can be used for new-home construction, subject to the requirements of the specific loan program and lender. Your plans, builder, budget, property, and financial qualifications will all factor into approval.
Is a construction loan right for me?
If you're ready to build instead of buy, a construction loan may give you a path to finance the project from the ground up. The best place to start is with a lender who can review your plans, budget, land, and financial situation and explain your options before construction begins.
Ready to build? Let's talk about your plans.
