A construction loan sounds pretty straightforward. Historically, borrowers got them when building a new home on a plot of land. In recent years, more borrowers have been using construction loans for projects like an accessory dwelling unit (ADU), a tiny house on a foundation, garage-to-apartment conversion, or basement conversion. But there are complications with this kind of loan that people should be aware of.
We’ll take a look at construction loans, their requirements, and some alternatives to consider.
Table of Contents
What Is a Construction Loan?
Construction loans finance the building of a new home or substantial renovations to a current home. They are typically short-term loans with higher interest rates, designed to cover the costs of land, plans, permits and fees, labor, materials, and closing costs. They also cover contingency reserves if construction goes over budget.
How Do Construction Loans Work?
When you buy a house, you can finance the purchase with a mortgage. But when you build a house, getting financing is trickier because there’s no collateral to guarantee the loan. Lenders generally don’t accept undeveloped land as collateral because it cannot be easily appraised and quickly sold.
With construction loans, applicants must submit project plans and schedules along with their financial information. Once approved, they receive funding for the first phase of building only. As construction progresses, assessments are provided to the lender so that the next round of funds can be released. Meanwhile, borrowers make interest-only payments on the funds they’ve received.
When construction is finished — and the borrower now has a home to serve as collateral — the construction loan may be converted to or paid off by a regular mortgage. The borrower then begins repaying both the principal and interest.
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What Does a Construction Loan Cover?
What construction loans cover varies based on the borrower’s needs. If necessary, these loans can cover the cost of the land, building labor and materials, permits, and a contingency cushion for unforeseen expenses.
Types of Construction Loans
Construction-to-Permanent Loan
Sometimes referred to as a single-close loan, this is a construction loan that converts to a mortgage once the project is finished. The borrower saves money on closing costs by eliminating a second loan closing.
Construction-Only Loan
Also called a standalone construction loan, this loan must be paid off when the building is complete. You will need to apply for a mortgage if you don’t have the cash to do so.
Having separate construction and mortgage loans allows homeowners to shop for the best terms available when applying for each loan. However, they will pay separate closing costs on each loan.
Renovation Construction Loan
This is specifically designed to cover the cost of substantial renovations on an existing home. The loan gets folded into the mortgage once the project is complete.
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What Are the Requirements for a Construction Loan?
It’s typically harder to get a construction loan than it is to secure a mortgage. Some people even hire construction loan brokers to facilitate the process. Because your house or ADU isn’t built yet, as we mentioned above, there’s no collateral. And because there’s no collateral, lenders will want to see strong evidence that the home will be completed.
A loan that doesn’t require collateral is also known as an “unsecured loan.” You can learn more about the two types of loans in our guide to secured vs. unsecured loans.
With renovations, the lender wants to see that the project will add to the value of the home. To get an idea of the ROI on your renovation project, check out SoFi’s Home Project Value Estimator.
In order to get approved, you’ll have to show your potential lender an overview of your financial profile, with plenty of documentation. They’ll typically want to see a debt-to-income ratio of 45% or lower and a high credit score.
For new construction projects, they’ll also want you to be able to make a down payment of up to 30%. And for construction-only loans, they may want to know what your repayment plan is — that is, whether you will pay in cash or refinance when the project is complete.
In addition, the lender will want a detailed plan, budget, and schedule for the construction. Some lenders will also need to approve your builder. Because the project will depend on the builder’s ability to complete the construction to specifications, your builder’s reputation may be crucial to getting a construction loan approved.
Lenders typically need to see a builder’s work history, proof of insurance, blueprints, and specifications for the project, a materials list, and your signed construction contract.
What Are the Average Interest Rates and Terms?
Typically, construction loans have variable interest rates that rise and fall with the prime lending rate. They tend to be higher than conventional mortgage rates by about 1%.
The terms also vary. A construction-only loan is usually a short-term loan that must be converted or paid off in one year.
A construction-to-permanent loan will typically have a term of 15 to 30 years once it becomes a permanent mortgage. Again, though, the interest rate will usually be higher than a conventional loan because of the increased risk. The longer the term, the higher the rate tends to be.
Are There Alternatives to Construction Loans?
A lot of time and effort may go into securing a construction loan. It can be difficult to find lenders that offer competitive rates and to qualify for them — particularly if you don’t have a flawless credit history. Plus, construction loans tend to be complicated because it is often the builder who has to carry the loan.
If you are planning a small construction project or renovation, there are a few financing alternatives that might be easier to access and give you more flexibility.
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Personal Loans for Renovations
An unsecured personal loan can fund a renovation project or supplement other construction financing.
Personal loan interest rates are typically lower than construction loan rates, depending on your financial profile. And you can frequently choose a personal loan with a fixed interest rate.
Personal loans also offer potentially better terms. Instead of being required to pay off the loan as soon as the home is finished, you can opt for a longer repayment period. And getting approved for a personal loan can be much faster and easier than for a construction loan.
The drawbacks? You won’t be able to roll your personal loan into a mortgage once your renovation or building project is finished.
And because the loan is disbursed all at once, you will have to parse out the money yourself, instead of depending on the lender to finance the build in stages.
Cash-Out Refinance for Construction Costs
A cash-out refinance is also a good financing tool, particularly if you have a lot of equity in your current home. With a cash-out refinance, you refinance your home for more than you owe and are given the difference in cash.
You can estimate your building or renovation expenses with this Home Improvement Cost Calculator. Add your estimate to what you owe on your home to get the amount of your refinance.
Using one — or both — of these alternative financing tools may help you avoid some of the hassle and expense that come with construction loans.
The Takeaway
Planning a new home, ADU, or substantial renovation? A construction loan may be the ticket, though this kind of loan is usually harder to get than a mortgage, often carries a higher interest rate, and is typically short-term. For smaller projects, a personal loan or cash-out refinance can be a good option — and a lot less complicated.
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