Building your dream home is an exciting endeavor, and securing the financing for a new construction project requires careful planning. Unlike a traditional mortgage for an existing property, a construction loan is a specialized type of financing designed to fund the building of a new home. This guide will walk you through the process of obtaining a construction loan, from understanding the basics to securing the best rates.

What Is a Construction Loan?

A construction loan covers the costs of land purchase, construction materials, labor, permits, and other expenses associated with building a home from the ground up. In a traditional mortgage, you receive a lump sum upfront; a construction loan is disbursed in stages as the construction progresses. These disbursements, or "draws," guarantee that funds are used for their intended purpose and help keep the project on schedule. Each draw is typically tied to a specific milestone, such as foundation completion, framing, or roofing.

Construction Loan vs. Mortgage

Construction loans differ from traditional mortgages in many ways. While both are used to finance real estate, they have distinct characteristics:

  • Purpose. Construction loans are specifically designed for building or renovating a house, while traditional mortgages are used to purchase an existing property.
  • Disbursement. Construction loans are disbursed in stages as the home building progresses, whereas traditional mortgages provide a lump sum upfront.
  • Interest Rates. Construction loans often have higher interest rates than traditional mortgages due to the risks associated with these projects, such as potential cost overruns, delays, and unforeseen circumstances.
  • Loan Term. Construction loans are typically short-term, lasting 6-12 months, while traditional mortgages have longer terms, such as 15 or 30 years.

Main Types of Construction Loans

There are many different types of construction loans available to build a house, designed to meet the various needs for homebuyers. When choosing a construction loan, consider factors such as your financial situation, the complexity of the project, and your long-term goals. The most common and often used home building loan types are construction only and construction-to-permanent. 

Construction-Only Loan

This type of loan covers only the cost of building a house. Once the construction is complete, you’ll be responsible for paying the entire loan amount in full. Those who use this type of loan typically cover the balance by paying in cash or taking out a new mortgage. The disadvantage of this construction loan type is that borrowers will have to go through the mortgage process twice and pay two sets of closing costs.  

Construction-to-Permanent Loan 

With a construction-to-permanent loan, you’re only responsible for interest payments on the money drawn, as it’s drawn. Once the building is complete, the loan will convert automatically into a traditional mortgage and you’ll make payments on the interest and principal. You’ll choose your term, usually 15 or 30 years, and can opt for a fixed or adjustable rate. This allows you to complete only one round of applications and paperwork. The downside of this loan type is a lack of flexibility if your building project goes over budget. If the construction costs exceed the initial loan amount, you may need to secure additional funding. 

Eligibility Criteria for a Construction Loan

Just like a regular home mortgage, construction loans come with requirements that borrowers must meet in order to qualify for the loan. 

  • A Good Credit Score. Generally, a credit score of 620 or higher is required for a home construction loan. 
  • Income. A stable employment history can strengthen your loan application.
  • Low Debt-To-Income Ratio (DTI). The DTI compares your monthly debts to your monthly income. Most lenders will accept a DTI of up to 45%, but lower is better.
  • Down Payment. Most lenders require a down payment of 20% for a home building loan. But this amount can vary by lender and some may allow less. 
  • Property Appraisal. The lender will appraise the property to assess its value and check that it meets their lending standards.

Key Documents Required for a Home Building Loan

To secure a construction loan and initiate the home building process, you'll need to provide the following documents to your lender:

  • Building Plans and Permits. Detailed architectural plans outlining the design and layout of your home, along with necessary permits from local authorities.
  • Contractor's License and Insurance. Proof that your contractor is licensed and insured to perform construction work.
  • Personal Documents. This can include pay stubs, proof of identity, recent tax returns, and bank statements. 
  • Land Purchase Agreement (if applicable). A legal document outlining the terms of the land purchase, including the purchase price, closing date, and any contingencies.
  • Detailed Construction Budget. A comprehensive budget that outlines the estimated costs of materials, labor, and other expenses associated with the construction project.

Securing the Best Home Construction Loan Rates

Construction loan interest rates can fluctuate based on various factors, including your credit score, the lender, and current market conditions. To secure the best possible rate, consider the following:

  • Improve your credit score. A higher credit score can significantly impact your interest rate. Work on paying bills on time, reducing debt, and disputing any errors on your credit report.
  • Shop around. Compare offers from various lenders, including banks, credit unions, and online lenders. Credit unions, in particular, often offer competitive rates and personalized service.
  • Choose a shorter loan term. A shorter loan term can lead to lower interest costs over time. Be sure to balance the shorter term with your budget.
  • Negotiate with your lender. While negotiating interest rates may not always be feasible, it's worth discussing with your lender,  especially if you have a strong financial profile and a solid construction plan.

By understanding the factors that influence interest rates and taking proactive steps, you can secure a construction loan with favorable terms.

Home Construction Loan Process

The home construction loan process typically involves three main phases. 

Pre-Construction Phase

The pre-construction phase sets the stage for a home building project.

  • Find your land. To find a suitable plot, consider location and potential for future development. Research the property’s history, zoning regulations, and potential environmental issues.
  • Hire a builder. Find a licensed, insured, and reputable contractor with experience and positive reviews. Look over the construction contract to understand the scope of work, timeline, and payment terms. 
  • Secure financing. Research lenders including banks, online lenders, and credit unions. Gather your documents and apply for a construction loan. You might secure more favorable rates if you belong to or join a credit union. 
  • Purchase homeowner’s insurance. Even though you aren’t living in the home during building, your lender will likely require this as a condition of your loan approval. 
  • Obtain permits and approvals. Hire an architect to design your home’s blueprint, obtain permits from local authorities to start building, and arrange for water, sewer, gas, and electric connections.  

Construction Phase

The construction phase is where your home takes shape. During this phase, expect:

  • Disbursement Draws. As the construction progresses, your lender will release funds to the builder in stages. These disbursements, or "draws," are typically tied to specific milestones in the construction process, such as foundation completion, framing, and roofing.
  • Regular Inspections. To make sure that the construction is progressing as planned and that funds are being used appropriately, the lender or a third-party inspector may conduct regular inspections. These inspections verify that the work meets quality standards and complies with building codes.

Post-Construction Phase

This last phase of the construction process finalizes the ownership of your dream home. 

  • Final Inspection. Once the construction is complete, a final inspection is conducted by a qualified inspector to make sure that the home meets all building codes and quality standards. This step is necessary to obtain a Certificate of Occupancy (CO), which officially declares the house habitable and allows you to move in.
  • Permanent Financing. After the final inspection is approved, the construction loan is converted into a traditional mortgage. This will have a longer term and a fixed interest rate.
  • Title Transfer. The final step in the process involves transferring the title of the property to the homeowner. This is typically done through a closing process, where all the necessary paperwork is signed and recorded.

When Ready to finance your dream home? HFCU offers competitive construction loan options to help you turn your vision into reality. Apply online today to secure the financing you need.