Construction Loans

Construction loans are short-term financing options that help you build a new home or tackle major renovation projects. Unlike traditional mortgages, which are mainly for buying existing homes, construction loans focus more on funding building projects.

What Exactly Is a Construction Loan?

A construction loan is a type of financing from a lender that helps you cover the costs of building a new home. The loan typically fits the unique needs of construction projects, so they are great for new builds or major renovation projects.

Usually, construction loans are short-term, lasting anywhere from one year to 18 months, depending on how big your project is. The loans help you get through the construction phase before you switch to a permanent mortgage for the finished property. 

How Construction Loans Work

These loans cover all the costs that come with constructing a residential, including buying the land and paying for labor and materials. The process is a bit different than a regular mortgage ― instead of getting a lump sum upfront, you get the funds in stages as your project progresses. This way, you can keep your finances better organized and make sure the money is used for its intended purpose.

Since building a home from scratch or doing major renovations can be a bit tricky and come with some level of financial risks, lenders usually want to see a few important project details before they give you the green light. These typically include things like:

• Detailed building plans
• Realistic budget estimates
• Project timelines

This way, lenders can make sure the project is feasible, you’re prepared to execute the project, and the project stays on track. See tips for choosing the right construction loan lender.

What Can a Construction Loan Cover?

Construction loans are pretty versatile when it comes to what they can help you pay for, whether you’re working on a new build or a major renovation. Here are some of the key things they can help with:

• Land Purchase: If you don’t already own the plot of land, a construction loan can help you buy it so you can get started on your project.
• Permits and Fees: You can use the loan to pay for important but pricey requirements, like building permits and inspections.
• External Services: Construction loans can also cover costs for external services, including hiring architects and engineers.
• Building Costs: These loans cover all the expenses associated with actually constructing your home, such as hiring contractors and buying materials.
• Renovation Expenses: They can help fund major upgrades, such as kitchen remodels or adding an extra room. And if you’re looking to buy an existing property and give it a total makeover, construction loans can help with that, too. Explore various home renovation projects.

Types of Construction Loans

Construction-Only Loan

A construction-only loan solely finances the construction phase of your building project. Typically, this type of loan lasts for about a year or less. You’ll only pay interest on the amount you draw during construction. But once the building is done, you’ll need to either pay off the loan or refinance it into a mortgage.

While you might score better terms with the new mortgage, keep in mind that this option can get pricey. You’ll have to pay closing costs twice for two separate loan transactions.

Construction-to-Permanent Loan

A construction-to-permanent loan is a two-in-one financing option that covers both the construction phase and then turns into a regular mortgage once you complete your building project. During construction, you only pay interest on the money you use. Once the home is complete, the loan switches to a traditional mortgage, where you start to pay off the principal and interest.

Renovation Loan

If you’re ready to take on some major improvements, a renovation loan is what you want. Some renovation loans, like the FHA 203(k) loan, help you purchase the property and pay for the renovations all in one go. The amount you can borrow is based on what the home will be worth after all the work is done. If you have already purchased the property, then you can get a RenoFi loan, which will also be based on the after renovation value, but will not require you to refinance your first mortgage. 

Owner-Builder Loan

These types of loans are designed for homeowners who plan to act as their own general contractor during construction. An owner-builder loan lets you manage the construction yourself, so any draws you make go directly to you instead of a third-party contractor. Keep in mind that lenders will usually want you to have experience as a homebuilder or a contractor’s license. Learn about RenoFi’s contractor due diligence.

Bridge Loan

A bridge loan is a short-term financing option that helps you get the funds you need while you wait to secure a more permanent loan for your construction project. Homeowners looking to build a new home often use this loan to help them sell their current one first. This type of loan helps “bridge the gap,” so it’s easier to transition to your new place without financial stress.

End Loan

An end loan is a long-term loan that you secure to pay off a short-term construction loan or other temporary financing. Once your home is built, the end loan replaces the short-term construction loan you used while building your home.

Once your house is complete, the end loan gives you long-term financing with a stable monthly payment. It’s common to get both the construction and end loans from the same lender, which simplifies the application process and paperwork.

Things to Keep in Mind Before Taking Out a Construction Loan

Taking out a construction loan is a big financial decision that requires careful consideration. Here are some important factors to keep in mind before you proceed:

Eligibility Requirements

Construction loan lenders have some specific criteria they look for to see if you qualify to get the loan. Here’s what you usually need:

• Good Credit Score: A credit score of 680 or higher is important for getting approved for a construction loan, so make sure your score is in that range or above.
• Down Payment: You’ll typically need to put down about 20-30% of the total project cost, so be ready for that.
• Proof of Income: You’ll need to show that you can cover the mortgage payments once your home is finished.

Costs and Fees

Construction loans have their own costs and fees, and they can be pricier than traditional mortgages. Besides the interest rate, you might have to pay for things like loan origination fees, appraisal fees, and inspection costs. So, be sure to factor these expenses into your overall budget to avoid any surprises later on.

Disbursement of Funds

Unlike many regular mortgages, where you get the full loan amount upfront, construction loans release funds in stages as the project progresses. This is known as a “draw schedule.” It’s super important to work closely with your lender to understand exactly how and when these funds will be released.

Transition to Permanent Financing

Once your building project is done, you’ll need to switch to a permanent mortgage. To make this transition easier, it’s a good idea to look into your options for permanent financing ahead of time and to understand what’s required.

Construction Loans vs. Traditional Mortgages vs. RenoFi Loans: Which Is Better for Renovations?

If you’re looking to finance your renovation projects, here’s a quick comparison of the common options:

Construction Loans

Construction loans are typically meant for building projects, which means they can be a bit tricky to use for funding your home renovation projects. Here are some reasons they may not be the best fit for renovations:

• Interest Rates: Construction loans sometimes have higher rates than traditional mortgages, but it really depends on factors like your credit and the current market. If you have strong credit, the difference may not be as pronounced. It’s worth looking at the big picture to see if it makes sense for your renovation.
• Short Repayment Period: Construction loans typically have a short repayment term, usually around 18 months or less. Once the construction is complete, you’ll need to refinance into a permanent mortgage, which can add extra costs and complexity.
• Complicated Draw Process: With these loans, the lender releases funds in stages as your project progresses, meaning you won’t have access to all your money upfront. This process can slow down your renovation and create cash flow issues. See 3 reasons why you shouldn’t use a construction loan for your renovation.

Traditional Mortgages

Traditional mortgages are great for buying existing homes but aren’t designed for financing renovations. The only way you would typically use one for renovations is through refinancing your current mortgage. However, the funds from refinancing may not always cover extensive upgrades. Besides, it could involve higher closing costs based on the new loan amount. 

RenoFi Loans

RenoFi loans are tailored specifically for renovations and offer some significant advantages:

• Access to More Money: RenoFi loans let you borrow against your home’s future value after renovations. This gives you access to more funds without the high costs associated with construction loans.
• Full Access to Funds at Closing: With RenoFi loans, you get the full loan amount distributed at closing, whether it’s a home equity loan or a HELOC. This means you have all the cash you need right from the start, so you can kick off your renovation without waiting for funds to be released in stages.
• Lower Interest Rates: RenoFi loans often offer competitive interest rates, depending on your situation. This could make managing your monthly payments more affordable compared to other options, but it’s important to compare rates based on your specific financial profile. Compared to construction loans, RenoFi loans typically come with lower interest rates. This way, it’s a lot easier to manage your monthly payments.
• No Need to Refinance: With RenoFi loans, you don’t have to worry about refinancing after your project is done. This means you avoid the extra costs and hassle that come with closing on a new mortgage.
• Simpler Process: The application process for RenoFi loans is straightforward, and you can get your funds without the complicated draw system that comes with construction loans. 

Learn how RenoFi simplifies the home renovation loan process.

Benefits of RenoFi

Before you proceed to take out any home loan for your renovations, keep in mind that RenoFi differs from a traditional home loan. While a traditional 90% LTV HELOC might seem like a good way to fund your home renovation, it often falls short because the equity you have isn’t enough to cover everything on your wish list.

One solution is to consider your home’s after-renovation value, which can help increase the equity available to you—this is exactly what RenoFi loans do.

For instance, let’s say your home is currently worth $500,000, and you still owe $400,000 on your mortgage. If you plan to renovate and believe your home will be worth about $640,000 after the work is done, your current loan-to-value ratio (LTV) is 80%. This means you can’t borrow anything to fund your renovation with a traditional loan. Learn more about LTV.

However, a RenoFi loan lets you go as high as 150% LTV or 90% LTV based on that after-renovation value. So, in this example, while a standard home equity loan would leave you with $0 borrowing power, a RenoFi loan would allow you to borrow up to $176,000 thanks to the increased after-renovation value of your home.

If you are considering a home renovation, RenoFi is by far the smartest way to finance your project. 

Get the Right Financing for Your Home Renovations With RenoFi

While construction loans might be a good fit for those looking to build from the ground up, a RenoFi loan is your best option if you plan to take on major home renovation projects. Our financing options are a lot easier to qualify for than many traditional loans, and we offer highly competitive rates. Plus, you can secure funding even if you haven’t built up a lot of equity in your home.

Additionally, our RenoFi loans are the smartest way to finance a home renovation project. Unlike traditional loans, which are based on your current home value or require you to refinance your primary mortgage and give up your low rate, RenoFi loans are based on the after-renovation value of your home. This allows you to borrow, on average, 11x more, get a low monthly payment, and keep your low rate on your first mortgage. Get in touch with us today to find a suitable loan for your home projects.