A Beginner’s Guide for Residential Construction Loans

Photo of author
Written By KennethChing

Loanproof.co.uk emerged from a shared vision: to make loan management accessible and understandable for everyone.





A Beginner’s Guide for Residential Construction Loans

It can be difficult to buy a home. The first step is to search through all available properties on the market. Next, narrow down your choices based upon your preferred location, price, style, and features. Residential Construction Loans After you have found the perfect property, you will need to complete the offer process. Once your offer is accepted, you can begin the mortgage process.


A third option is to build your dream home. Although you’ll still have to make a lot of work to build your dream home you can also add all the extras you need.

It’s not just this way that new construction differs from buying an existing home. Also, the loans are totally different.

What is a construction loan?

More specialized financing options are required if you intend to hire your own general builder. A construction loan, which is typically a 12- to 18-month loan, is used to finance the cost of building a custom home.

The following are some of the costs that a construction loan might cover:

  • Lot or parcel of land to build upon
  • Architectural plans
  • Permits
  • Labor
  • Materials
  • Contingency funds (if your project goes over budget)

How does a construction loan work?

Because there is no home that can be used to secure the loan (like a traditional mortgage), the application and approval process are more complicated. Your financial situation and project plans will be reviewed by your lender.

A key difference between construction loans, traditional mortgages, and construction loans is that construction loans can be used as a line credit, rather than a lump sum. Based on the relationship between the lender, builder and subcontractor, the lender may pay installments (to the builder or to suppliers) as different stages of the construction are completed. Before making each payment, your lender might request an inspection to evaluate the progress.

Kim Moore, Mountain America Credit Union assistant vice president of mortgage sales, said, “During construction, most construction loans only require that you pay the interest on the funds as they are paid. The loan will be converted to a permanent mortgage once the project is complete. You’ll also need to be eligible for a new loan to repay the construction loan.

There are many types of construction loans

There are many options for building a home. You might choose to tear down an existing house and use the “bones” for a rebuild, or to start from scratch on a blank plot of land. There are many construction loans that can work for you, so you have options.

Because construction loans can vary from lender to lender, it is important to shop around for the best possible option for you. The most popular types for construction loans are

Construction only loan– This loan is short-term and can be fixed- or adjustable-rate. It’s used to finance construction costs. After the project is finished, the loan must be refinanced into mortgage or paid in full. You will need to submit two separate loan applications and have two closings if you choose this type of loan. This option is great for borrowers who have cash in their pockets or who plan on paying off the construction loan along with the sale and purchase of their old home.

Construction-to-permanent loan–These loans also are short-term loans that cover the construction costs–but they convert automatically to a permanent fixed- or adjustable-rate traditional mortgage once the home is completed. Interest-only payments will be made during construction. This is an excellent option for those who are looking to lower closing costs and secure mortgage financing.

Renovation loan- Akin to a regular mortgage but with the same insurance, renovation loans can be used to purchase a home or pay for construction costs. These loans are also known as 203(k), or mortgages. These loans are popular for homeowners buying a fixer-upper with plans to do extensive renovations. Another benefit? A bonus: Borrowers only have one loan payment even though they are renovating and buying property.

Other options to finance a renovation are available that don’t fall under construction-specific loans. Moore says, “There are also refinance, home equity, and line of credit options for homeowners who have equity in their home.”

Loan for the owner-builder – This loan is a great option if you are a general contractor. Be aware that you will likely need to prove that your qualifications are sufficient to oversee construction projects.

You can apply for a long term loan, which is basically a traditional mortgage. This could work for your case if the construction loan you have is not set up to convert into a traditional home mortgage.

Construction loan requirements

As we said, obtaining a construction loan can take longer than traditional mortgages. Due to the shorter term and the lack of a home to secure the loan, there is a higher risk for the lender. More risk means more requirements.

These are the items your credit union/bank will consider when approving you.

  • Credit score – A good-to-excellent credit score is necessary to get a loan for construction. However, lenders might require something more–possibly as high as 720. Before applying for a loan for construction, make sure you have a good credit rating. Each of the major credit bureaus will provide a free credit check once a year.
  • Income – The lender will want you to have enough income to cover your construction loan payments, as well as any other financial obligations. They will ask for documentation to prove your income each year.
  • The Debt to Income ratio (DTI), This shows how your monthly debt payments compare to your gross monthly earnings. The DTI you have, the less cash you need to repay the loan. Try to get a DTI of less than 45%.
  • Downpayment–Lenders generally require a minimum downpayment of 20%. Some may require more. Although you might be able to pay less than 20%, this will often result in your payment being subject to private mortgage insurance (PMI). When shopping around, make sure you compare all the details.
  • Budget and plans As long as all is in order, the more details you give your lender, your chances of approval are higher. Along with a detailed budget and complete architectural plans, your lender might also ask for the deed or purchase agreement for the land where you are building, as well a payment schedule, qualifications for builders or contractors (licence, insurance certificate, proof that they have experience) and a signed contract.