Whether you’re building a new home or renovating an existing one, you may not have money in the bank to cover all the costs. Luckily, you can borrow money to pay for this type of project with a construction loan.

What is a construction loan?

A construction loan is used to finance the building or renovation of a home (or other real estate projects). They are used to cover the cost of the project before long-term funding—like a traditional mortgage—is obtained. Construction loans are short-term, high-interest, and typically last for one year.

How does a construction loan work?

Before you’re granted a construction loan, you’ll need to provide your lender with a construction timeline, details, and budget. All of this information will factor into the final loan amount, as well as the draw schedule.

Because a construction loan is used to pay for the labor and materials needed during construction, it’s doled out in “draws” or “tranches,” a series of payments that sync with different phases of the construction timeline. This schedule typically aligns with the completion of major milestones, like when the home’s foundation is laid, when plumbing is completed, etc. Your loan provider will decide what the draw schedule will be and send an inspector to regularly check on the progress of the build before approving the next draw.

During construction, you’ll likely only be required to make interest payments on your construction loan. Once the project is completed, you will likely need to convert the construction loan to a traditional mortgage (a construction-to-permanent loan), pay the loan in full, or get a separate mortgage designed to pay off the construction loan.

How do I get approval for a construction loan?

Since construction loans carry more risk than a traditional mortgage, interest rates tend to be higher. With a traditional mortgage, the physical house is used as collateral: if you don’t pay your mortgage, the lender can seize your home. With a construction loan, the collateral doesn't exist yet. This means the lender will likely look more carefully at your finances, income, and credit score to determine your ability to pay for the project.

But before even applying for a construction loan, you’ll need to do a few things:

Find a licensed builder: This shows the lender that you’re hiring a professional, experienced home builder. Make sure to check the contractor’s previous work, references, and license number to ensure it’s still active.

Gather documents: The contract with your builder, architectural plans, and pricing, as well as personal financial information, needs to be vetted by your lender. You’ll need to show that you can provide a down payment of anywhere from 5% to 20%, as well as the income to continue paying the loan and interest. They will also look at your credit score. Typically, the minimum credit score required for most USDA and conventional construction loans is 620.

Get pre-approved: This is the process that determines how much you can borrow. If your lender of choice does not approve your loan for the amount you were hoping for, you can either try a different lender or figure out how to lower your construction costs.

How do I pay back my construction loan?

There are a few options for paying back a home construction loan:

  • End loan: After construction is completed, you can get a new loan to pay off your construction loan.
  • Refinance: Take out a new loan, typically at a lower rate of interest, likely a permanent mortgage. (With Welcome Homes, your construction loan converts to a traditional mortgage of your choice with no additional closing costs once a Certificate of Occupancy is issued.)
  • Pay outright: Some construction loans require that the entire loan be paid in full by the time construction is completed.

You’re ready to build your home – now you just need the money. With a home construction loan, you can receive the funding you need to start building your dream home.

Ready to build the home of your dreams? Get started today.