How Do Construction Loans Work? A Complete Guide

If you’re getting ready to start a major construction project, you’ll need to sort out your finances. Even minor construction projects can be expensive and can put a dent in your wallet.

One of the most common ways to finance construction projects is through construction loans.

If you’re wondering, “how do construction loans work?” here is everything you need to know!

What Is a Construction Loan?

Construction loans enable you to pay the costs associated with buying land for the home. The builder receives money through advances made through the process.

You will be responsible for paying the interest for the project over the initial months after you take the loan. This could include anywhere from 6-24 months.

Different Types of Construction Loans

One of the essential construction loan tips is to know which type of loan is right for you. This includes a construction-to-permanent loan. The loan terms begin as a construction loan, and once the home is built, the loan transitions to a mortgage loan.

An end loan is another type of construction loan. This occurs when the builder pays for the construction of the building, and the buyer takes out a mortgage to purchase the building from the builder.

An owner-builder construction loan allows you to play both parts as the builder and buyer. If you have significant experience in home building, this may be right for you.

If you’re renovating instead of rebuilding, consider a renovation loan. This allows you to borrow against the estimated value of your renovated home.

You can also consider builder construction spec loans which allow you to be involved in the building construction from start to finish.

How Do Construction Loans Work?

Even though construction loans help finance your project, they carry stiffer requirements than traditional loans.

For example, with mortgage loans, your collateral is your home. If you can’t make your payments, you will lose possession of your home. But, with construction loans, this collateral doesn’t exist.

As a result, lenders assume more risk when signing off on construction loans. Because of this risk, you need to meet more requirements to be eligible and approved by lenders.

Some of these requirements include a high credit score, 20% down payment, substantial savings, a signed contract with a licensed builder, and detailed construction plans.

Most of the time, the initial terms of a construction loan end after about a year. Following this period, you’ll either need to pay the balance of the loan or apply for a traditional mortgage loan. Most conventional mortgage loans last between 15-30 years.

Now You Know the Basics About Construction Loans

So, how do construction loans work? Now, you know!

Construction loans aren’t as complicated as you may think and they can help you get the money you need to finance your project. If you have any questions about which construction loan is right for you, reach out to your financial advisor to discuss potential options.

And to learn more tips about your home building, be sure to check out the rest of our blog. We have a ton of other helpful blogs that you’ll love!