What Is a Construction Loan?

A construction loan is used to finance the building of commercial or residential real estate. The loan applicant may be a real estate developer or an individual building a custom house. The loan is often short-term and is then replaced by longer-term mortgage financing.

Construction loans are considered relatively risky and usually have higher interest rates than traditional mortgage loans.

How a Construction Loan Works

Construction loans are usually for only one year. After construction is complete, the borrower can either refinance the construction loan into a permanent mortgage or obtain a new loan to pay off the construction loan (sometimes called an “end loan”). Some borrowers take out a construction loan that is automatically converted to a mortgage loan once the home is completed. This is known as a construction-to-permanent loan.

The borrower might be required to make interest-only payments on a construction loan while the project is underway. Some construction loans may require the balance to be paid off entirely by the time the project is complete.

If a construction loan is taken out by an individual who wants to build a home, the lender might pay the funds directly to the contractor rather than to the borrower. The payments may be made in installments as the project completes new stages of development.

Construction loans can also be taken out to finance rehabilitation and restoration projects as well as to build new homes.

Eligibility Requirements for Construction Loans

Construction loans tend to have tougher credit requirements than conventional mortgage loans because they are not collateralized. The home doesn't yet exist, so it can't be seized for non-payment of the loan. Construction loans are usually offered by local credit unions or regional banks. Local banks tend to be familiar with the housing market in their area and are more comfortable making home construction loans to borrowers in their community.

Most lenders require a 20% minimum down payment on a construction loan, and some require as much as 25%.

Borrowers will face difficulty securing a construction loan if they have a limited or damaged credit history or too much other debt outstanding. To gain approval for a construction loan, the borrower will need to give the lender a comprehensive list of construction details (also known as a “blue book”). The borrower will also have to prove that a qualified builder is involved in the project.

Construction Loans vs. Owner-Builder Construction Loans

Borrowers who intend to act as their own general contractors or build the home with their own resources are unlikely to qualify for a construction loan. These borrowers will have to take out a variant called an owner-builder construction loan. It can be difficult to qualify for an owner-builder construction loan. Potential borrowers must offer a well-researched construction plan that convincingly lays out their home-building knowledge and abilities. The borrower should also be able to set aside a contingency fund for unexpected costs.

Example of a Construction Loan

Jane Doe decides that she can build her new house for a total of $500,000 and secures a one-year construction loan from her local bank for that amount. They agree on a drawdown schedule for the loan. In the first month, $50,000 is required to cover costs, so Jane takes only that amount—and pays interest only on that amount. Jane continues to take funds as needed, guided by the drawdown schedule. She pays interest only on the total that she has drawn down rather than paying interest on the whole $500,000 for the entire term of the loan. At the end of the year, she refinances the loan, folding the construction costs into a lower-interest mortgage on her dream home.

The Bottom Line

If you want a unique home and don't possess a fortune in cash, a construction loan could be an answer to your dreams. To qualify, however, you must be prepared to prove to a bank that you have a complete project plan in place and a qualified contractor to carry it out.