Understanding Construction Loans | Build With Confidence

If you're considering building a house, you might be wondering about the financing options. Constructing a home requires a specific type of loan called a construction loan. Unlike a standard mortgage, this loan is specifically designed to cover expenses such as land, labor, materials, and permits.

It's important to note that construction loans come with their own distinct features and requirements, setting them apart from traditional mortgages. Let's examine how construction loans work and what you need to know before applying.

people transferring money next two model home

What is a Construction Loan?

A construction loan is a specialized type of loan tailored for individuals or entities looking to build a home or commercial property. Unlike traditional mortgages that provide a lump sum for the purchase of an already existing property, construction loans offer a more dynamic financing solution. Funds from a construction loan are disbursed in phases, corresponding with various milestones of the construction process.

This flexible approach means that as each significant phase of the building project is completed—like laying the foundation, framing, or finishing work—the lender releases a portion of the total loan amount to cover these costs. Typically short-term with higher interest rates, construction loans require the borrower only to pay interest on the portion of the loan disbursed during the construction phase. Upon completion of the project, the loan balance is either paid in full or converted into a traditional mortgage, making it a flexible solution for financing new constructions.

How do construction loans work?

The process of obtaining a construction loan typically involves the following steps:

To apply for a construction loan, you will need to submit financial documents, plans, and project timelines.
Once your application is approved, you can begin to draw funds in installments as the work progresses. Generally, during this time, you only need to repay the interest.
During the construction process, a qualified appraiser or inspector evaluates the progress at significant stages to approve further funding.
After the construction work is completed, you have the option to repay the loan or convert it into a permanent mortgage and repay the principal and interest.

One-time close vs. two-time close

One-time Close

A one-time close construction loan, also known as a construction-to-permanent loan, is a type of loan that combines the construction loan and permanent mortgage into one. This means you only have to apply and close once for both the construction and permanent financing. Once your home is finished, the loan automatically converts into a mortgage with the same interest rate and terms that you initially agreed upon. It simplifies the process and reduces costs, but it may have stricter qualifying criteria compared to traditional construction loans.

Two-time Close

If you opt for a two-time close construction loan, you will have to go through the application and closing process twice. First, you will need to apply and close for the construction financing and then again for the permanent financing. This type of loan provides the advantage of allowing you to find the best mortgage rate and terms after the construction phase is complete. However, during the construction phase of your mortgage, your interest rate is not fixed and is subject to market fluctuations. This means that your final permanent mortgage interest rate may change based on market conditions at the time of completion. It's important to note that a two-time close loan requires two separate closings and associated fees, which makes it more expensive upfront compared to a one-time close loan.

Here are six crucial steps to consider when building a new home:

Determine your budget for the new home construction and add a buffer for any unexpected costs.
Research and carefully choose a new home builder since you will be working closely with them for up to a year or longer.
Learn about your county’s new home construction permit process, as well as insurance requirements.
Understand how funds will be released to the builder during construction.
Understand how loan payments are made during construction.
Understand how the new construction loan will be converted to a long-term mortgage once the home is finished, and plan accordingly. This understanding will equip you with the knowledge and preparation needed to smoothly transition from the construction phase to the long-term mortgage phase.

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