What Is a Construction Loan & How Do They Work?

A comprehensive guide to understanding what construction loans are and how the process works; from qualifying and applying to draw schedules, approvals and more.

If someone has told you that using a construction loan was the best way to finance your renovation project, you should really know all the facts.

You see, this type of loan sounds great because it lets you borrow based on the after renovation value of your home, helping you to finance your wishlist all in one go.

And until recently, these were the only real options for homeowners to borrow in this way. Now, other options exist, and these are typically better-suited for renovations.

Understanding construction loans

To help you to make the right decision as to the best way to finance home improvements, we’ll talk you through exactly how construction loans work, giving you the information that you need to make the right decisions about financing your renovation.

We also want to introduce you to an alternative financing route that will likely be better suited to your needs.

What is a construction loan?

Quite simply, here’s what you need to know about construction loans:

  • They’re loans for the purpose of building a home from the ground-up, that some people also use for major renovations as well.
  • They have a progressive drawdown, meaning that you (or your contractor) receive the loan amount in installments.
  • They’re short-term loans that convert to a permanent mortgage.
  • These loans require refinancing, meaning you’ll need to sacrifice any existing rates you’ve locked in.
  • They often have higher interest rates & fees than traditional mortgages.

How do construction loans work?

Construction loans are a pain in the butt; both for you as a homeowner and your general contractor.

And what you need to understand is that construction loans were never originally intended to be used as a way to finance renovations, rather as a way to turn a plot of land into a new home. Something that, as you’d expect, carries a lot of risk.

For this reason, a complex set of stringent requirements are put in place to protect the lender.

These same requirements must be adhered to by anyone who takes out a construction loan, regardless of whether that’s to finance a remodel or a new home construction.

They’re a one-size-fits-all loan and don’t take into account the specific circumstances surrounding the project.

This means that there’s a lot more work involved by all parties than with other types of home renovation loans.

In fact, some of these requirements are actually why many contractors hate construction loans for renovations.

But we said we’d help you to understand how construction loans work, so that’s what we’ll do, specifically breaking this down into four stages:

Step 1: Qualifying for a Construction Loan

The first stage of taking out a construction loan is qualifying for it, and in order to help you understand exactly how this works and what the specific criteria are, we’ll review this in two parts: the basics of construction loans and loan-to-value (LTV) ratio.

The Basics of Construction Loan Criteria

Here are the basics that you need to know about qualifying for a construction loan:

Residence Type:

Construction loans are for owners who are planning on living in the home (either primary residences or vacation homes).

Construction loans are not fix-and-flip loans , but are loans that can be used to help long-term homeowners find ways to pay for a home renovation.

Credit Score:

Construction loans are typically offered by community & regional banks. They typically require a higher minimum credit score to qualify, often 700 or above.

(Note: FHA 203K & Fannie Mae Homestyle loans have lower credit score requirements but those loans are not covered in this post).

Debt-to-Income Ratio (DTI):

Your debt-to-income (DTI) ratio is the comparison of your income and debt payments, and it’s at the crux of not only construction loans, but most other lending too (in fact, it’s one of the most common reasons why homeowners can’t qualify for a RenoFi loan).

Construction loan approvals typically require less than 43% of your income to go towards your proposed house payments, combined with all other debt that you have.

For example, if your gross income is $10,000 per month (before tax), your future house payment + auto loan payments + student debt + credit card bills, and other debt repayments should not exceed $4,300 per month (43% of your $10,000 monthly income).

Understanding Construction Loan-to-Value (LTV)

Just like a normal mortgage, the Loan-to-Value ratio is key for understanding how a construction loan works.

This ratio is simply referring to the % of your home that you will own and what % is being borrowed.

If you buy a home and make a 10% down payment, as an example, the Loan-to-Value is 90%.

With construction loans, you are able to borrow based on the expected future value of the home, after the renovation, rather than the current value.

Here’s a simple example:

Meet the Jenkins family.

They are looking to take out a construction loan of $250,000 to pay for home improvements.

They expect their home to be worth $750,000 after the construction, and they have an outstanding mortgage of $350,000.

Their total mortgage, after works have been completed, will be $600k ($250k + $350k), making their Loan-To-Value 80% ($600k / $750k).

And it’s important to know that, while each lender sets its own Loan-to-Value requirements, 80% is generally the max, but there are some lenders that will allow you to go all the way up to 90%.

Step 2: Preparing to Apply

Applying for a construction loan is, in some ways, similar to applying for a mortgage, with some additional steps that are unique to this type of loan.

But ultimately, construction loans are a type of mortgage loan.

And as with any mortgage, you will be required to provide the typical income and asset documentation, and below, we’ll specifically cover the elements you will need outside of a typical application that are specific to the construction loan process.

Contractor Approval

Lenders want to be sure the contractor you’ve chosen has a strong reputation and track record before they approve your construction loan; they’ll want to approve your choice.

This extra level of scrutiny gives homeowners additional peace of mind and supplements any diligence they did on their own.

But once a builder is approved by a bank, they don’t have to be approved again, meaning that if your builder or general contractor is not already on the approved list of the bank you are applying to, they will need to go through an approval process.

Your banker will provide their own specific forms, but generally, the builder will need to fill out an application and provide the following:

  • Documentation of the builder’s licenses
  • Documentation of general liability & workers comp insurance
  • References from past clients & material suppliers
  • Documentation proving they are current on their payments to subcontractors

Whilst a builder who is able to satisfy the requirements of the lender shouldn’t have issues getting approved, it can delay the application process.

Home Renovation Plans

In order to estimate what your home will be worth AFTER your renovation is complete, the bank will need to see detailed plans of what the project will entail and how the loan is being used.

These plans will ultimately be handed over to an independent appraiser who is responsible for coming up with that estimated future value.

In conjunction with your builder, you will need to provide the following:

  • Blueprints/building plans & detailed specifications
  • Fully executed contract between you and your builder
  • Building permits if applicable
  • Contracts for all estimates outside of the construction contract

Step 3: Draw Schedule & Approvals

One of the big things that you need to know about construction loans is draw schedules and approvals.

You see, these loans are unique in the way you access the funds to pay your contractor.

Even though your lender has approved your builder, they are still cautious.

Here’s an example:

Let’s say you are doing a $200,000 renovation.

When taking out a construction loan, the bank isn’t just going to cut a check to your builder for $200,000 upfront.

If you were paying cash, you’d pay in installments as the project progressed, based on certain milestones, thus reducing the risk.

Lenders are the same.

This helps them to ensure that the funds are being used to enhance the collateral; your renovated home.

And they do this by creating a draw schedule.

Using the $200,000 example, a draw schedule might be broken down into five $40,000 payments, with each one corresponding with a milestone being met in the project.

Once the builder has hit the milestone, they request the draw from the bank.

And with each draw request, the bank will send a certified inspector to your home to verify the work was completed to the required standard.

In turn, while this creates a fantastic set of checks and balances that protect both the homeowner and the bank and is an integral part of how construction loans work, it ultimately causes delays in projects.

When the contractor makes a request for a draw, they have to go through the individual process for that specific bank, which chances are—they’ve never done before.

The bank will then order an inspection from a third party, which can take anywhere from a few days to over a week.

After the inspection, the contractor and the homeowner will have to sign approvals for the additional draw.

Step 4: Converting To a Permanent Mortgage

For the sake of this guide, we are assuming this a construction loan with a single close.

But what is a single close?

Construction Loans are actually two loans in one.

  1. Construction Loan: Construction loans are short-term loans that cover the construction period, usually up to 12 months. Typically borrowers pay interest only during this period.
  2. Permanent Mortgage Loan: These are most typically either traditional 30-year fixed mortgages or 10 to 20-year Home Equity Loans.

A single close simply means that it’s one construction loan that combines both of the above loans, so as the borrower you only have to pay closing costs/fees once and only have to deal with one set of paperwork.

While separating the two loans and having two closings with two sets of closing costs/fees could make sense in very specific situations, in our experience, the vast majority of times, a single close is the way to go as it saves homeowners time & money.

Once the construction is complete, the loan automatically converts to a permanent loan.

It’s that simple!

But, that doesn’t mean that this type of loan is right for you, and in most instances, homeowners have better-suited alternatives available to pay for renovations.

Is a Construction Loan Right for Me?

With the tedious paperwork and lengthy draw process, construction loans may not always be the best choice, either for you or your contractor.

And we’d estimate that, for 9 out of 10 homeowners renovating, that’s the case. But the one main reason why people use construction loans in this way is to benefit from higher borrowing power.

The good news is that there is an alternative type of home renovation loan, RenoFi loans, that will allow you to borrow based on your after renovation value versus your current home value without all of the extra work associated with construction loans, plus the added bonus of low monthly payments and interest rates.

RenoFi Loans vs Construction Loans

Whereas construction loans are plagued with complexities and negatives such as the requirement to refinance, higher costs, and more work for everyone involved, a RenoFi loan can help you to borrow the money you need to complete your entire wishlist in a simpler and more cost-effective manner.

To put it simply, a RenoFi loan gives you the benefits of construction loans without the downsides that you’ve learned about.

In other words, by financing in this way, you can get the most money for your project without the higher monthly payments, additional costs, frequent headaches, and refinancing requirements.

Side-by-Side Comparison

Renovation Home Equity LoanSingle-Close Construction To Permanent Loan (CTP)Fannie Mae HomeStyle LoanFHA 203k (Full)Two-Close Construction To Permanent Loan (CTP)
Is this a mortgage?YesYesYesYesYes
1st or 2nd mortgage?2nd1st1st1st1st
Require refinance of existing mortgage?NoYesYesYesYes
Typical Interest RateMarketAbove MarketAbove MarketAbove MarketAbove Market
Loan Limit (Renovation Cost + Mortgage)$500,000Jumbos allowedConforming only$Conforming onlyJumbos allowed
Loan Term (max)20 years30 years30 years30 years30 years
Credit Score Required660+700+620+580+580+
Loan to ValueUp to 95%Up to 95%Up to 95%Up to 96.5%Up to 80%
Can be used for building new home?NoYesNoNoYes
Restrictions on type of improvements?NoNoNoYesNo

Don’t choose a construction loan just because you’ve not looked into your alternatives when a better option almost certainly exists. And we’re here to help.

Use our RenoFi Loan Calculator, schedule a call or chat online with one of our advisors today, and we’ll show you how you can benefit from a RenoFi loan.

How do I know if a RenoFi loan is right for my project?

The RenoFi team is standing by to help you better understand how RenoFi Loans work and the projects they are best suited for. Have a question - Chat, Email, Call now...