An Expert Guide to Construction Loans, and How They Work

If you’ve been told that using a construction loan was the best way to finance your renovation project, you should read this guide to be sure you really know all the facts!

Homeowners often overlook the fact that construction loans are short-term “builder loans” by design.

Before applying for a construction loan, it’s crucial to ensure you truly understand how construction loans work, to ensure you select the best loan type for your needs.

Construction loans sound great because they let 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. But now, other options better suited for renovations exist!

In this comprehensive expert guide, we’ll delve into everything you need to know about construction loans as well as the alternative financing options you should explore before applying!

Let’s dive in and explore all there is to know about construction loans, shall we? 

What Is a Construction Loan? 

A construction loan is a specialized short-term loan designed to finance new construction projects or the renovation of fixer-uppers.

These loans are temporary, usually with terms ranging from six months to a few years, and once the construction is completed, the borrower typically refinances from a construction loan into a permanent loan.

Simply put, construction loans are a cross between a hard money loan and a traditional mortgage.

Yet still, when comparing a construction loan vs a mortgage it’s important to note that construction loans have much higher interest rates, fees, and shorter terms.

The Bottom-Line:

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

Construction Loan Expert Tip: A pivotal success factor to construction loans is managing construction timelines/schedules. It’s essential to comprehend that “banks typically provide a construction time frame of 12-18 months,” advises Mathew Garland, renowned as “MG the Mortgage Guy,” a Specialist in Real Estate Financing for Homebuyers and Investors. Considering that “permits can often take 6-8 months,” as highlighted by Mathew Garland, in most scenarios it may be more fitting to opt for home equity loans or lines of credit if you do not have a large sum of funds to start on your renovation project.

Construction Loan Interest Rates

Construction loans have variable interest rates, meaning that they adjust based on a prime rate or index over the life of the loan.

The introductory rate you’re offered will depend on a number of factors, including your credit score, the loan amount, the loan term, and the lender’s policies. In general, construction loan interest rates tend to be 1% above traditional mortgage interest rates. 

Use a loan calculator to assess if you can afford payments based on the interest you’re offered.

Construction Loan Expert Tip: Boost your chances of securing a lower interest rate by considering a larger down payment, showcasing financial commitment, and reducing lender risk.

If a substantial down payment isn’t feasible, explore alternatives like utilizing a RenoFi Loan to access competitive rates.

How Does a Construction Loan Work?   

Construction loans work differently from traditional home loans as they are specifically designed to finance the major construction/building of properties. As such, the construction loan process is a more intricate financing option for construction projects because it involves multiple inspections, paperwork, and signatures.

Due to these intricacies construction loans work in stages which include: borrower approval, builder approval, project approval, construction, and re-financing.

Learn how each stage of construction loan financing works below:

Borrower Approval Stage

First comes the borrower approval (or pre-approval) stage where lenders aim to assess your financial stability and history. Typically lenders are interested in assessing the following;

• Creditworthiness
• Income history
• Assets
• Occupancy
• Liabilities

Builder Approval Stage

Following, the lender looks to approve a builder for a construction loan. Lenders aim to ensure that the builder is qualified, reputable, and capable of successfully completing the construction project. Typically lenders are interested in assessing the following;

• Builders Credit
• Track Record/Project History
• References and Portfolio
• Supply Chain and Subcontractor Relationships
• Licenses, Bonds, and Insurance

Construction Loans Expert Tip: It’s imperative to confirm that your builder is pre-approved by your lender or possesses a proven track record of successfully completing projects of similar scope. Most lenders are unlikely to approve a construction loan if the builder lacks experience in undertaking projects that align with your intended scope. Aim for a contractor with atleast 2-3 years experience with your scope of work.

Project Approval Stage

Next, is the project approval stage of a construction loan, lenders are focused on ensuring that the proposed construction project is feasible, well-planned, and aligns with the terms of the loan. Here are the key aspects that lenders typically evaluate when approving a construction project:

• Project Scope, Timeline, and Detailed Costs Breakdowns
• Signed Contracts
• Title
• Renovation Plans, and Permits
• ** After-renovation value before approving the loan (based on home appraisal)**

Construction Loans Expert Tip: Securing a construction loan necessitates precision. Ensure a meticulous cost breakdown, encompassing materials, and a steadfast fixed-cost contract. Recognize that lenders seldom endorse contracts with open-ended expenses, as their approval hinges on precise project valuation. By presenting a comprehensive breakdown and unwavering contract, you bolster your eligibility and set the groundwork for a successful loan application and project realization.

Construction Stage

Then, comes the construction phase, at which point you’ll have to make interest-only payments on the drawn amount. Then, the funds are typically disbursed in stages or “draws” throughout the project. These loans are unique in the way you access the funds to pay your contractor.

One of the big things to manage with a construction loan is the draw schedules and approvals.

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.

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

Construction Loan Expert Tip: Once your construction loan is locked in, interest payments begin. Consider leveraging an interest reserve account—a savvy move to take care of the accruing interest during the construction phase, easing your financial flow until your home is fully built.

Lenders frequently establish an interest reserve account for you during the closing process, streamlining the management of interest payments as your dream home takes form.

Re-Financing Stage

Last, once the construction is complete, you’ll need to convert to a permanent mortgage via a re-finance. This is because refinancing the construction loan into a permanent mortgage allows you to secure a more stable and cost-effective financing option for the property in the long run.

Although refinancing is common with construction loans, from our experience we find it to be a lot wiser to consider cost-effective financing options like a RenoFi Loan from the start. 

Construction Loan vs Mortgage

Below are the key differences between construction loans vs traditional mortgage features. Use the table below to compare the major features of both loan types.

Construction Loan Requirements

Below we detail how to qualify for a construction loan:

• Minimum Credit Score of 680: Construction loans typically require a higher minimum credit score to qualify, often 680 or above.

• 43% 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 because it helps measure your financial stability. 

  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.

• 20% Down Payment: You will need a 20%  down payment of the loan amount, and if you pay less than that, you will probably pay private mortgage insurance (PMI). But this can vary by lender. Some may require up to 30% down payment of the loan amount.

• Licensed Builder: You’ll need to have a reputable, licensed builder selected before you apply for your loan. You’ll want one with a proven resume of quality projects and a member of a credible trade group, such as the National Association of Homebuilders (NAHB). 

• Home Appraisal: A thorough home appraisal is essential for obtaining a construction loan. It evaluates the property’s current value and its potential after construction or renovation. The appraisal helps lenders assess the project’s feasibility and determine your loan amount.

• Construction Plan: Detailed construction plans are vital for a construction loan application. They provide a blueprint of your project, including scope, costs, and timeline.

  Lenders use these plans to evaluate the project’s viability and align the loan amount with the proposed work. Submitting a comprehensive construction plan increases your chances of securing financing for your home renovation project.

Construction Loan Expert Tip: As of 2023, securing a construction loan is notably influenced by your credit score. While the minimum score stands at 680, the size and intricacy of your construction project could necessitate a higher credit or fico scores.

Best Type of Construction Loans

1. Renovation Loans

A home renovation loan is a type of loan that provides funding specifically for home improvement projects.  Like construction loans, a home renovation loan uses after renovation value, to determine how much you can borrow. There are several home renovation loans, such as a RenoFi loan, a Fannie Mae Homestyle loan, and an FHA 203k loan.

If you’re looking for a way to finance your renovation project and get the highest possible borrowing power (often by more than 11x) at the best possible rates and lower fees, a RenoFi HELOC or RenoFi Home Equity Loan is the way to go.

Best For: “For renovations starting at $25,000 or so, a home equity loan or line of credit may be appropriate, if the homeowner has built up equity in their home” says Steve Kaminski, head of U.S. Residential Lending at TD Bank.

Renovation loans are best suited for homeowners planning significant home improvements, homebuyers interested in fixer-uppers, and individuals lacking sufficient cash reserves for renovations. These loans offer a convenient way to finance large-scale remodeling projects and increase home value while providing flexibility in loan terms and fixed interest rates.

Pros:

• Substantial funding for large projects
• Versatile use of funds
• Competitive interest rates
• Predictable monthly payments
• Potential tax benefits
• Streamlined application process
• Lower interest rates than most construction loans

Cons:

• Adds to existing long-term debt
• Collateral requirement
• Sometimes requires a considerable amount of  home equity

2. Construction-Only Loans

A construction-only loan is a short-term loan specifically designed to finance the construction of a new home or significant construction project. Construction-only loans (or stand-alone construction loans) only cover financing for the construction of the home itself. 

Many often wonder if they can get a loan to build a house - the answer is yes, a construction-only loan is used for building homes.

Since construction-only loans solely cover the costs of construction, once the project is complete, you must choose to either refinance the loan into a construction-to-permanent loan or sell the property. These loans are truly best suited for borrowers with a large amount of money on hand and/or who are planning to sell the home upon completion with confidence. 

Best For: Construction loans are best suited for individuals who want to build a new home or undertake major construction projects for homes they intend to later sell rather quickly (i.e. real estate investors). These loans are ideal for those who have substantial funds to cover construction costs and are willing to manage the complexities of the construction process due to near-future potential profit margins.

Pros:

• Permanent financing flexibility: Choose better rates for 

Cons:

• Higher closing costs
• Higher interest rates 
• Limited lender options
• High chance of funding delays
• Short repayment window

3. Owner-Builder Loan

An owner-builder loan is a type of loan specifically designed for individuals who plan to act as the general contractor or builder for their own home construction or major renovation project.

These loans are designed for homeowners acting as the general contractor for the construction or a homeowner who may be professional builders themselves. Since many lenders are more hesitant to work with anyone who isn’t a licensed builder, these loans are often structured with clear incremental completion dates to ensure the project is well-managed, accurately budgeted, and on time.

Best For: Owner-builder loans are best suited for individuals who have the expertise and experience to act as the general contractor for their own construction project. These loans are ideal for skilled individuals who want to have full control over the construction process, manage subcontractors, and oversee the project from start to finish. 

Pros: 

• Instant home equity boost
• Potential construction cost savings
• Greater control of the project 

Cons: 

• Difficult to obtain the loan
• Higher interest rates
• Multiple closing (which means additional fees/costs)

4. Construction-to-Permanent Loans

A construction-to-permanent loan, also known as “end loans”, “single-close” or “all-in-one” loan, is a type of mortgage that combines both the financing for the construction of a new home and the permanent mortgage for the completed property into a single loan package.

With this type of loan, borrowers only go through the application and approval process once, and the loan automatically converts from the construction phase to a traditional mortgage after the construction is completed. 

Best For: Construction-to-permanent loans are ideal for borrowers who have a clear vision of their desired home design and are willing to manage the construction process because the bank will only pay the builder when construction progress is made or completed.  

Pros: 

• One set of closing costs
• Fixed interest rate
• Savings on closing costs

Cons: 

• Larger down payment
• Higher credit requirements
• Limited flexibility
• Higher interest rates

5. Land Loans

A land loan is a financial product designed to provide funding specifically for the purchase of raw or undeveloped land.

Unlike traditional mortgages that finance the purchase of a home or property with existing structures, land loans focus solely on acquiring the land itself. A land loan is one way of financing the empty lot that you plan to build on.

There are several options that each cover different types of land from raw land that has been untouched to improved land, which has access to utilities and roads and is ready for building. Following a similar process to a traditional mortgage, these loans use the property purchased as collateral and can be paid back over time. 

Best For: These loans are suitable for those who want to invest in land for personal use or as an investment and have a clear plan for construction or development.

Pros: 

• Flexible deadlines
• Single-close options 

Cons: 

• Difficulty selling the land
• Tougher qualifying criteria 
• Fewer lender options

How To Get a Construction Loan

Is it hard to get a construction loan?

Construction loans are harder to get than traditional mortgages because they have stricter eligibility criteria. It’s a rigorous process that requires a number of things that have to be prepared for your lender in order to qualify for a loan. 

Lucky for you, these steps will ensure you’re well-prepared!   

Step 1: Secure a Licenced Builder or Contractor

One of the crucial preliminary steps in obtaining a construction loan is finding a reputable and experienced contractor to handle your construction project.

Securing a qualified contractor is vital for a successful loan application and a smooth construction process. When finding a contractor or builder we recommend that you do the following;

• Research contractors, ask for recommendations from friends and family
• Verify credentials such as licenses, bonds, and insurance
• Check work portfolio and client references
• Review contractors experience
• Get detailed cost estimates, a project scope, and a fixed-rate signed contract

Step 2: Prepare Financial Documents 

This stage is extremely important in order to qualify for a construction loan. There are a number of documents you’ll need to provide your loan advisor or loan officer in order to show your lender that you aren’t a risky investment.

You’ll need to provide documents that are similar to that of the traditional mortgage project such as proof of income, bank statements, credit report, and property information for the application process. 

Specific document requirements may vary by the lender typically you’ll need what we’ve listed below;

• Proof of income 
• Bank statements
• Employment verification
• Credit report
• Building plans and specifications
• Construction contract
• Contractor contact information
• Cost estimates for the construction
• Project timeline and schedule

Construction Loan Expert Tip: As part of the application process, the lender will request architectural plans or working drawings from you and a course of construction insurance policy is obligatory, with the insurance premium due after the construction loan is granted.

Step 3: Submit Your Application for Preapproval

During the preapproval phase of obtaining a construction loan, gather financial documents, check credit reports, and consult a loan advisor.

Preparing this information in advance will expedite the approval process and help you secure favorable terms. After you submit your construction loan application, the construction lender will order a home appraisal of the property.

Construction Loan Expert Tip: In 2022, the predominant reason construction loan approvals faced hindrances was inadequate valuations. Safeguard against this setback by procuring an early “as-completed” home appraisal for your construction project.

Step 4: Get Insurance

Begin by researching reputable insurance providers that offer comprehensive coverage for construction projects. Obtain quotes and compare policies to find the best fit for your needs.

Once you’ve chosen an insurer, promptly notify your lender and provide the required documentation to prove your coverage aligns with their stipulations, and pay your premiums. Ensuring your chosen insurance meets lender requirements will contribute to a seamless construction loan process.

No Money Down Construction Loans

The notion of securing a construction loan without a down payment can be appealing, promising an expedited path to project commencement - but it’s rare.

Exploring a USDA loan as a construction loan option can be a strategic move, especially if you’re aiming to build a home in a rural or suburban location. With the potential for no down payment, competitive interest rates, and accessible credit requirements, a USDA loan can be a valuable tool to facilitate your construction project.

However, it’s important to note that USDA loans do come with certain eligibility criteria. The property you intend to construct must be located in a designated rural area, and your income should fall within specified limits.

Construction Loan Expert Tip: Truthfully, USDA loans are best suited for first-time home buyer renovations. If you’re not a first-time home owner you’re better off exploring alternatives, particularly home equity loans and lines of credit (HELOCs).

These avenues leverage your property’s equity, (and do not normally require a down payment) which enables you to fund your construction project with more favorable terms, competitive interest rates, and the flexibility to move forward confidently.

Choosing the Right Construction Lender

Select the best construction loan lender for you by asking the following questions and assessing each lender’s answers against your unique needs:

• What types of construction loans do you offer?

• What is the interest rate and how is it determined (fixed vs variable rate)?

• What are the terms of the loan, including the repayment schedule?

• What fees are associated with the loan, such as origination or processing fees?

• How are the funds disbursed during the construction phases?

  Find a Lender

Construction Loan Expert Tip: Initiating your lender search involves identifying banks within your zip code that provide construction loans. While prominent institutions like Wells Fargo, Bank of America, and Chase typically underwrite such loans, securing financing from these giant banks can be a challenge due to their focus on traditional mortgage lending.

Consider focusing on local credit unions and smaller banks, particularly those acquainted with your region and familiar with your property’s post-renovation potential value. These institutions tend to more readily approve construction projects they deem low-risk.

To promptly connect with a credit union lender or regional bank, RenoFi streamlines the process and offers quick solutions.

Construction Loan Disadvantages You Must Consider

At this point, you may just be wondering: is a construction loan a good idea?

According to Abrigo, in the first quarter of 2023, “construction loans made up 3.82% of all loans and leases, up from 3.73%”.

Construction loan financing has seen an uptick in 2023 but for the majority of homeowners, construction loans are still not a good idea. This is because “construction debt is hard to get,” said Matt Enzler, senior managing director for the North Texas division of Dallas-based developer Trammell Crow Residential.

The intricacies of obtaining approval for a construction loan, coupled with high-interest rates and complex draw processes, should not be overlooked. That being said, it’s important to research all your construction loan alternatives — and RenoFi can help.

When considering a construction loan for remodeling projects, here are a couple of construction loan risks you may be up against.

• Cost Overruns and Budget Management
  Since the loan amount is determined in advance, you have little flexibility in the event of unexpected costs. Any change or modification to your project can increase your costs, but that doesn’t mean you’ll have access to the funds at that time to cover it. As a result, you can end up delaying your project or looking for secondary financing to make up for the difference.
•  Managing a Complex Construction Process Construction loans are a lot of work! And with a construction loan, there are a lot of extra steps required of your contractor throughout the process — which neither you nor your contractor will probably love. Between the requests for each draw, inspections from a third party, and signed approvals, the process can be very tedious and drawn out.
• You Won’t Get Your Money Right Away
  Despite all the extra work, the bank may not even give your contractor the full draw. Some lenders will withhold 10% of each request—known as a holdback—until the end of construction when a final inspection is performed to ensure everything was completed as expected. And let’s just say whenever your contractor has to pay out of pocket to keep a project moving, they aren’t thrilled about it.
• Payment Structure
  Once you’re approved for a construction loan, you don’t receive the amount in one lump sum. Instead, you and your builder will receive it in a series of draws — acting similarly to a line of credit. During construction, you only pay interest on the loan. These monthly payments are calculated and applied based on only what you draw each month. Repayment on the loan itself will start
  
  When it comes to a down payment, the lender will suggest a down payment reflecting the difference between the approved loan amount and the construction costs. This will usually have a minimum of 20% of the loan amount.
• Construction Loans Terms
  Since these loans are typically used to pay for materials and labor in building a home, they’re typically issued for a period of 12-18 months. But some of these loans will convert to a permanent mortgage when construction is complete. 
• Construction Loan-to-Value (LTV)
  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:

The Summer family is 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%.

How to Obtain Expert Assistance in Finding a Lender For Your Project

Use a loan advisor before getting a construction loan because they can provide expert guidance and help you navigate the complexities of the loan process and selecting a lender. A loan advisor can assess your financial situation, understand your construction plans, and recommend the most suitable loan options tailored to your needs.

Considering RenoFi as your loan advisor is a smart choice because we specialize in low-interest-rate home renovation loans, including the RenoFi Home Equity Loans, RenoFi HELOCs, and more! We’ve helped fund over 1 billion dollars worth of renovation projects, and our expertise in this field allows us to personally help you access competitive interest rates, and ensure a smoother loan approval process.

For more information, contact RenoFi to discuss your renovation project.*

FAQs on Construction Loans