Building a new home is an exciting yet challenging process. One of the most important decisions you’ll make is how to finance the construction of your new home. Getting a construction loan tailored to your needs can make the process smoother and more affordable. This comprehensive guide will explain everything you need to know about new home construction loans so you can make the best financing choice.
What is a Construction Loan?
A construction loan, also called a self-build loan, is a short-term financing option meant solely to cover the costs of building a new home. Construction loans provide periodic payouts to the builder during different stages of construction.
Construction loans are very different from traditional mortgages in a few key ways:
- Shorter Term: Construction loans are short-term loans that provide financing for 6-12 months during the building phase. A separate permanent mortgage is required once construction is complete.
- Multiple Payouts: Funds are issued in installments as construction milestones are met, rather than a lump sum. This ensures the work is completed before sending more money.
- Interest-Only Payments: During the construction period, you only need to pay interest on the money that has been advanced so far. You don’t pay down the principal until the permanent mortgage starts.
- Higher Rates & Fees: Construction loans require more administration for the lender, so interest rates are higher and there are added fees.
A construction loan covers all hard costs like materials and labor up to the maximum loan amount. You’ll also need to pay soft costs such as permits, utility hookups, and architectural plans.
Construction Loan Interest Rates
Interest rates on construction loans tend to be higher than rates for traditional mortgages. This accounts for the added risk and administration required by the lender.
Here are some factors that influence construction loan interest rates:
- Credit score– Borrowers with higher credit scores qualify for lower rates. Scores below 620 may disqualify you.
- Loan-to-Value (LTV) Ratio– The ratio comparing your loan amount to the completed home’s value. Lower LTV means lower rates.
- Length of Loan– Shorter construction loan terms usually have lower rates.
- Fixed vs Variable Rate– Fixed rates are slightly higher but variable rates can fluctuate.
- Construction Draws– More frequent payouts equate to higher fees and rates for increased lender oversight.
- Top vs Bottom of Market– During high demand, rates tend to rise as banks’ resources get stretched.
A good credit score and substantial down payment will put you in a better position to get approved and secure a competitive interest rate. Shop around with multiple lenders to find the best construction loan rates.
Construction Loan Fees
In addition to higher interest rates, construction loans also come with significant fees to be aware of, commonly referred to as “points”. Here are some common fees charged for construction lending:
- Origination Fee– Upfront fee to initiate the loan, from 0.5% to 2% of the total loan amount.
- Underwriting Fee– Charged for the lender’s review and approval process, around $1,000 – $1,500.
- Inspection Fees– Paid each time the lender inspects completed work, around $100 per inspection.
- Draw Fees– Charged every time a construction draw is requested and paid, usually $50-$150 per draw.
- Change Order Fees– If modifications require revising the loan, a fee of around $100 or more applies.
- Closing Costs– Typical closing costs still apply, like appraisal, application fees, attorney charges, etc.
Factor these added expenses into your total construction budget. Getting pre-approved can give you an accurate estimate of total fees so they don’t take you by surprise.
Construction Loan Eligibility & Requirements
Construction loans have much more rigorous eligibility and documentation requirements compared to standard mortgages:
- Down payment– Typically 20-25% down is required. Some lenders may accept 10-15%.
- Debt-to-income ratio– Your total monthly debt divided by gross income per month. Below 43% is ideal.
- Credit score– At least 620, but 720+ scores get better rates and approval odds.
- W-2s & tax returns– Documentation of your income and employment.
- Building plans & specifications– Fully detailed plans you’ve had professionally drawn up.
- Itemized budget– A comprehensive budget for all costs associated with the new home build.
- Permits & approvals– Proof you have the proper permits, zoning, and inspections.
- Construction contract– Formal contract with your licensed general contractor.
- Contingency fund– Proof you have 15-20% of the total budget saved for cost overruns.
Be prepared to provide extensive paperwork proving you are low-risk and able to pay for the project in full. Meeting all requirements will get you the green light.
How Construction Loans Work
Now that you understand the basics of construction lending, let’s look at how these specialized loans actually work from start to finish.
Loan Application & Approval
First, you’ll submit your construction loan application and all required documentation to the lender for review. If approved, you’ll get a loan estimate outlining the costs, fees, and terms you’re agreeing to.
During underwriting, the lender will assess:
- Your finances and creditworthiness
- The collateral value of the land/property
- Reviewed plans, permits, and budget
Once approved, you’ll pay your upfront fees and sign the final loan documents. Make sure you understand all the terms before signing!
Initial Land Draw
If you’re also financing the land purchase with your construction loan, the lender will issue an initial payout to cover this cost.
Construction Draws
Now the building can begin! Your general contractor will handle each stage of construction. The lender will schedule periodic inspections to verify progress and work completed.
Once the inspection confirms the stage is done, the contractor submits a construction draw request to the lender. The lender releases funds needed to pay for that portion of the project.
Draws are typically spaced 30-60 days apart depending on the length of the build. The number of draws varies, but often between three to five in total.
Final Draw
After the final inspection, the last construction draw will be released once all work passes inspection and preliminary paperwork is submitted. Any remaining contingency funds will be paid to you.
Loan Conversion
When construction is complete, your construction loan must be converted to permanent financing. This is most often done through getting a traditional mortgage.
Using a lender that offers construction-to-permanent financing makes this process simple. You’ll just change over to the permanent mortgage with the same lender once the home is finished.
The permanent mortgage payments will be higher accounting for principal paydown. But you’ll benefit from better rates and terms over the long-term loan.
Finding the Best Construction Loan Lender
Choosing the right construction loan lender is crucial. You want an experienced lender familiar with the unique process, risks, and requirements. Here are some tips for picking the best lender:
- Shop around– Compare multiple lenders on rates, fees, and closing costs. Get free quotes before applying.
- Ask about the experience– Choose a lender with extensive construction lending experience and a strong portfolio.
- Read reviews– Look for positive customer reviews on responsiveness, flexibility, and transparency.
- Prioritize communication– Clear communication throughout the process makes things smoother.
- Check for speed– The lender should commit to quick draw turnarounds and fair inspections.
- Inquire about conversions– Ask if they facilitate construction-to-permanent financing.
- Look for stability– Pick an established lender that won’t leave you high and dry. Avoid new or struggling companies.
Doing your research to find the right construction loan partner can save you time, money, and headaches through the building process.
Construction Loan Calculator
One useful tool for planning your new home construction project is using a construction loan calculator. This allows you to estimate your total monthly payments, see how loan fees impact your bottom line, and optimize your loan amount.
Here are the key pieces of information needed to use a construction loan calculator:
- Loan amount needed
- Interest rate offered
- Length of construction loan term
- Total upfront fees and closing costs
- Down payment amount
- Length of permanent mortgage term
- Estimated permanent mortgage interest rate
With these inputs, a construction loan calculator will estimate:
- Total monthly payments during construction
- Total interest paid over the construction loan term
- Impact of loan fees on total cost
- Permanent monthly mortgage payments for budgeting
Being able to model different loan scenarios and terms allows you to make an informed financing decision. Optimizing your loan can save tens of thousands over the construction period and lifetime of your mortgage.
Online calculators make it easy to compare rates and payments across multiple lenders’ offers to identify your best option. Be sure to use an accurate and up-to-date calculator for reliable results.
Construction Loan Risks & Drawbacks
While a construction loan is necessary for most home builds, there are some downsides and risks:
Contingency overages – Even a 20% cushion may not cover unexpected costs, leaving you to pay more.
Short payback period – The 6-12 month term leaves little flexibility before converting to a mortgage.
No rate locks – Variable rates can rise over the course of the project, raising payments.
Limited customization – Modifications require lender approval and potentially added fees.
Increased fees & closing costs – Much higher than a standard mortgage.
Strict draw schedule – The lender’s payment schedule may not align with contractor needs.
Missed inspections – Late inspections can hold up the draw schedule and completion.
Incomplete work – If the home can’t be finished for any reason, you still owe the construction loan balance.
Delays or flaws – Any construction issues put you behind schedule or over budget.
No occupancy – You usually can’t move in until completion and conversion to permanent financing.
Contractor problems – Shoddy or unfinished work by the contractor can derail the project.
While they allow you to build your dream home, construction loans require close oversight and planning to avoid pitfalls.
Alternatives to Construction Loans
Construction loans are the most common financing method for custom home building. But here are a few other options that may be a better fit depending on your situation:
Portfolio loan – Some banks may fund your construction as part of their lending portfolio at more favorable rates.
Private loan – You may be able to secure a private loan from an individual with more flexibility.
Line of credit – A HELOC or business line of credit can provide accessible funds but at higher rates.
401(k) or IRA – You may be able to borrow against your own retirement savings and pay yourself back.
Owner-builder – If you act as your own GC, you only need small payouts for materials and labor costs as they come up.
Custom lender – Non-bank specialty lenders cater to unique cases but charge higher fees.
Cash payment – Paying in full in cash avoids loans, but you give up leveraging benefits.
Depending on your timeline, risk tolerance, and financing preferences, one of these alternative construction funding options may suit your needs better than a traditional construction loan.
New Home Construction Loans FAQs
Do I need a construction loan to build a new home?
In most cases, yes. A construction loan allows periodic payouts for completed work phases rather than a single lump sum. This protects you from contractor risk. Very few buyers building a custom home have the cash to pay the full amount upfront.
Should I use a bank or credit union for a construction loan?
Banks and credit unions offer very competitive construction loan rates and terms, with the benefit of stability. Online lenders offer faster turnarounds but less support. Go with who offers you the best deal.
How do construction loan payments work?
During the build phase, you’ll only pay interest on the amounts disbursed so far, not the full amount. Payments are due monthly to cover the interest charged during that period. Your precise payment will depend on your loan balance, rate, and how many draws have been issued.
Can I get a construction loan for an existing property?
Yes. If you wish to completely renovate or add a major addition to a home you already own, a construction loan can provide financing for this purpose.
What credit score is needed for a construction loan?
Construction loans require excellent credit, often at least 720. Anything below 620 will likely disqualify you. The higher your score, the better the interest rate you can secure.
Should I get pre-approved for a construction loan?
Yes, getting pre-approved allows you to lock in an interest rate and gives you negotiating power when making offers on land. It also shows sellers and contractors you are serious. Completing upfront underwriting makes the final application faster.
How long do I have to repay a construction loan?
In most cases, you will need to convert your construction loan into permanent financing within 6-12 months of completion. Longer terms are rare but may be possible with some lenders. Expect to transition into a traditional mortgage once construction is done.
What happens if construction is delayed?
Communicate immediately with your lender if any delays come up that will push the project past the original end date. Most lenders will extend the term by a certain period, but additional extensions or fees may apply. Have backup savings for overruns.
Can I get a construction loan for a manufactured home?
Yes, construction loans can be used to finance the on-site build of a manufactured or modular home. Just like a site-built home, the funds will be issued in phases as the home components are put into place on your property.
What if construction costs end up higher than expected?
Ideally, your 20% contingency will cover any cost overruns. But if you exceed your approved loan amount, you may need to inject more of your own cash or request a loan modification from the lender to increase the amount – likely subject to additional fees.
Wrapping Up
Building a home from the ground up is an ambitious undertaking filled with complex steps. Your construction loan is the financial foundation that makes everything possible. With sound planning and the right financing, you can turn your dream home into a reality.
Getting pre-approved, crunching the numbers, and truly understanding these specialized loans will give you confidence and control over the project. Partner with an experienced construction lender ready to provide guidance and support from blueprint to turnkey. Your dream home awaits!
Faizan Ahmad is a financial analyst and writer who specializes in investments, banking, and corporate finance. He has over 7 years of experience working in the finance industry in various roles.
He leverages his strong financial modeling and data analysis skills to provide insightful commentary on business, markets, and economic trends.
At Ventures Money, Faizan covers topics including Credit Card Reviews, Loans, Insurance, and Mutual Funds in the banking sector. He provides in-depth analysis of the latest news and trends to help readers make smart investment decisions.
Outside of writing, Faizan enjoys following the stock market, rooting for his favorite sports teams, and spending time with his family.