If you’re buying a home, odds are you’ll need to take out a mortgage to finance such a large purchase. But if you’re planning to build your own home from scratch, the type of financing you get to cover the cost of construction will differ.
More specifically, a construction loan will likely be required to finance your new build. But how exactly do construction loans differ from traditional mortgages?
Construction Loans Are Typically Only For the Short-Term
Unlike a traditional mortgage that offers long-term amortization periods, construction loans are only meant to be used for the short term. These types of mortgages usually last for no more than one year, while a typical mortgage can last anywhere between 5 to 30 years.
Ideally, construction will be completed by the time the construction loan term is up. When the term of the construction loan ends, the amount of money borrowed must be paid back in full. At this point, the loan can be refinanced into a permanent, longer-term mortgage or a new loan can be taken out in order to repay the construction loan.
Construction Loans Have More Stringent Criteria
The approval process for a construction loan differs from that of a traditional mortgage. You will likely be asked to submit detailed blueprints of the home you intend to build to the loan originator, along with an estimate of construction costs, proof that you’re working with a qualified builder, and a timeframe to complete the project.
Construction Loans Require a Bigger Down Payment
There are several different types of mortgages that have their own specific down payment criteria, some requiring as little as 3.5%. Construction loans, however, require a 20% down payment before a loan is approved; some construction loan originators may even ask for more. Depending on the cost associated with the construction and the loan amount required, the down payment amount needed can be rather significant.
The good news is that the down payment can come from the land where the home is being built, as long as it isn’t currently being financed and is owned outright in full.
Construction Loans Disperse Funds as They’re Needed
Another difference between a construction loan and traditional mortgage is that the former disperses the necessary funds in phases as they are required throughout the construction project. During home construction, there are usually five draws made based on what phase of construction the house is at.
For each draw, the borrower needs to submit a request, after which the lender will inspect the home prior to the funds being released. Only after the inspection is deemed satisfactory will the funds be given.
Construction Loans Come With Higher Interest Rates
Given the somewhat risky nature of construction lending, these types of loans tend to come with higher interest rates (usually variable) compared to the average mortgage.
Construction Loans Only Require Interest to be Paid on the Funds Released
Borrowers are only required to pay interest on the funds that the lender releases based on the phase of construction. If the entire loan amount isn’t used, the borrower doesn’t have to pay the entire interest amount. As more money is released with each completed phase, the amount of interest owed will increase. These are typically interest-only payments, after which the construction loan will be converted to a fixed mortgage once the construction of the home has been completed.
Construction Loans Typically Don’t Penalize For Early Repayment
The average mortgage usually has a stipulation in the details of the contract that outline any penalties associated with making early principal payments. Construction loans, however, usually do not penalize borrowers for early repayment of the remaining loan balance owed.
The Bottom Line
Building a new home from the ground up can certainly be an expensive endeavor, but with a construction loan, you don’t have to worry about coming up with a lump sum of cash to cover the costs associated with this type of project. While you’ll be responsible for coming up with a sizable down payment upfront, the remainder of the funds will be made available as they’re required throughout each phase of the project.
Be sure to speak with a licensed mortgage specialist who will fill you in on all the details about construction loans and help you qualify for one before construction starts.