Navigating the financials of building a new home can be as complex (and exciting!) as the home construction process itself.

At Ironstone Homes, we’ve learned that a clear grasp of how a construction loan works (and what construction loans cover) not only empowers you, the homeowner, but also smooths the path to stepping into your dream home. Whether you’re just considering building from scratch or are in the middle of choosing between home construction loans and a financing plan, this blog will help you with the basics of construction loans and home builder financing.

Key Takeaways

Construction loans are a financing arrangement offered just during the building phase of a home construction project and will be paid off entirely by, or converted into, a conventional mortgage after the construction phase is over. They are often floating rate, do require a downpayment, and are disbursed to the builder as milestones in construction are met.
Construction-to-permanent loans simplify the home-building journey by combining the construction financing and a mortgage into one package, minimizing paperwork and sometimes closing costs. A permanent loan allows you to transition seamlessly from a construction loan to a traditional mortgage, incurring only one set of closing costs, which can save you time and money.
Some builders (though not us) offer specialized financing programs or have established partnerships with lenders (we can help) who provide tailored loans for new construction. These sometimes come with perks like lower rates or closing cost contributions. Some developers offer creative solutions such as lease-purchase agreements or end loans that accommodate different buyer needs and financial situations, making it easier to transition into homeownership.

What is a Construction Loan?

A construction loan is a short-term loan used to finance the building or renovation of a home or other real estate project. They usually last a year or less.

Unlike traditional 15-year or 30-year mortgages, construction loans are short term loans, typically with a term of one year or less. They need to be paid off or converted into a long-term loan (generally a traditional mortgage loan) once the construction is completed.
The funds from a construction loan are usually disbursed in phases as construction progresses. Payments, or “draws,” are made directly to the contractor, not directly to the borrower, upon completion of predefined stages of work. As a custom home builder, we’re used to working under this strategy.
During the construction phase, the borrower often makes interest-only payments on the money that has been disbursed. This can help manage the cost of construction while the property is not yet providing you any functionality!
Construction loans are typically at a higher interest rate than standard mortgage loans due to the temporary nature and risk involved in financing a construction project.
Once construction is completed, the borrower usually needs to get a new loan, known as a “permanent” or “end” loan, to pay off the construction loan. This end loan is usually a standard mortgage.
A renovation loan is a specific type of financing designed to cover substantial home improvements, such as construction and rehabilitation projects. It can finance both the purchase and renovation of a home through manageable monthly payments, with various options available based on project cost and homeowner equity.

Construction loans tend to be common for those building a new home, and we’re very well-versed in working within lenders’ frameworks.

How Do Construction Loans Work?

Let’s illustrate this process with a fictitious couple named Ryan and Sally.

Step 1: Planning and Loan Application

Ryan and Sally meet with us to discuss their vision for a home to accommodate their growing family. They decide on a construction loan that offers flexibility and aligns with their financial goals. We put together a plan and timeline for their home build, plus a preliminary estimate for the project, and construction costs for their new home.

Step 2: Loan Approval and Initial Disbursement

The construction loan is approved by a lender specializing in such loans, often introduced or facilitated by Ironstone Homes‘ recommendations.

After a downpayment of some kind, a portion of the loan is disbursed to start the groundwork and foundation laying, with Ryan and Sally beginning to make interest-only payments on this amount.

Step 3: Construction and Subsequent Draws

As each major phase of construction is completed (like framing, roofing, interior finishes), the lender disburses further amounts of the loan. Ryan and Sally continue to pay interest only on the money that has been disbursed, keeping their initial expenses lower.

Step 4: Completion and Conversion

Once the construction is finished, and the home passes all inspections, the final disbursement is made.

The construction loan transitions into a permanent mortgage, often with the same bank, though not necessarily, reflecting a shift from interest-only payments to regular mortgage payments.

Step 5: Move-in and Long-term Financing

They complete any final paperwork and set up their long-term mortgage payments. Ryan and Sally move into their newly constructed home, enjoying the fruits of their well-planned investment!

This structured financial approach helps them stay on budget and transition smoothly into their new home. It’s a lot easier than it sounds, and banks see new home builds finances this way all the time.

Typical Construction Loan Requirements and Rates

Construction loan companies require borrowers to have a minimum down payment, usually 20% of the construction costs.

Borrowers must also have a good credit score, usually above 700.

Construction loan rates are typically higher than traditional mortgage rates, with the expectation that rates will be lower on the final permanent mortgages. Construction loan rates can often be variable, changing based on prevailing interest rates.

Prevailing permanent mortgage rates over the last forty years in the U.S. are around 5.0%, but have been as low as 2.0% after the Great Financial Crisis and into the 7%+ range during the interest rate hikes around 2022.

Construction Loan vs. Traditional Mortgage

Construction loans are short-term, while conventional mortgages are long-term.
Construction loans often require more documentation and regular updates from reputable builders, while traditional mortgages have more standard requirements.
Construction loans tend to have higher interest rates than traditional mortgages.
Construction loans can be riskier than traditional mortgages from the lender’s perspective, as the lender is financing a construction project that is not yet complete. The collateral (a half-finished home) is much less attractive than a fully finished home.

Permanent Mortgage Options

Once your new home is built, it’s time to transition from a construction loan to a permanent mortgage. A permanent mortgage is a long-term loan that replaces the construction loan after the building is complete. This type of financing is usually used to purchase a newly built home or to refinance an existing construction loan.

Permanent mortgages typically come with a fixed interest rate and a repayment term of 15 to 30 years. These loans can be obtained from a variety of lenders, including banks, credit unions, and mortgage companies.

Other Types of Construction Loans

In recent years, other approaches to financing new construction have emerged.

Construction-to-Permanent Loans: This is a popular option where the loan starts as a construction loan to cover the building of the home and then converts to a traditional mortgage once construction is complete. It can simplify the process by using a single loan application and closing process. One of the financing options available for building a home is construction-only loans, which require the borrower to pay off the full amount at the end of the construction.
Preferred Lender Partnerships: Some builders partner with specific mortgage lenders. While these partnerships can streamline the process and potentially offer special financing terms that are more attractive than standard options available in the broader market, it’s a good idea to talk to a range of lenders and loan officers to make sure you actually ARE getting the best rate for your situation.
Builder Financing Programs: Some builders have their own financing programs, providing loans directly to buyers. Sometimes these offer competitive rates or incentives like reduced closing costs to make the purchase more appealing, but again, make sure to look at the fine print and consider all of your options.
End Loans: Unlike a construction only loan, an end loan is a home mortgage loan that is used to pay off a construction loan once the home is complete. The buyer applies for this mortgage as they would for any home purchase.
Lease-Purchase Agreements: Some builders offer lease-purchase options, allowing buyers to rent the home with the intention to buy it after a certain period, sometimes using part of the rent paid as a contribution towards the purchase price. You’ll likely wind up paying more in the long-run under an arrangement like this.
Incentives and Subsidies: To attract buyers, some builders might offer various incentives such as paying points on a mortgage to lower the interest rate, offering upgrades at reduced costs, or assisting with closing costs. Just be careful that the incentives make sense for the purchase price and rates!
Land and Renovation Loans: Land loans only cover the cost of purchasing land that doesn’t have habitable structures on it. Renovation loans are available for upgrading an existing home and can be used for various projects, including major renovations, additions, or repairs.
Owner-Builder Loans: Owner builder loans are sometimes available for prospective home builders who wish to act as their own general contractor. These loans require the borrower to demonstrate expertise and experience in overseeing home construction. Owner-builder loans can be riskier than traditional construction loans in the eyes of the banking institute, as the borrower is responsible for managing the construction project.
Land Loan Options: Land loans are a type of financing that allows you to purchase a plot of land for future construction. Land loans are typically shorter-term than construction loans, with repayment terms ranging from a few months to a few years. The interest rates on these loans can vary depending on the lender, loan amount, and your creditworthiness. Some lenders may offer land loans with a balloon payment, which means you’ll need to pay off the loan in full after a certain period. One of the great things about land loans is that they can be used in conjunction with construction loans to finance the building of your new home.

Construction Loans Are Easier Than They Sound…

We understand that navigating construction loans and financing options for building a new home can seem daunting, but it’s easier than you might think.

With some guidance from an experienced builder, and a deep understanding of financing paths, we’re here to help make your path to homeownership clear and straightforward. Our experience with financial institutions and our commitment to making your home-building experience seamless translate into a less stressful and more enjoyable building process for you.

If you’re looking for a custom home builder in Lancaster, we can help. Call today to schedule a conversation about your goals!