What is a construction loan and how does it work?

Homes & real estate
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What is a construction loan and how does it work?

Homes & real estate

You’re finally ready to step up from renter to homeowner, but despite keeping an open mind on gas vs. electric ranges and ranch-style vs. open-floor-plans, you just can’t seem to find a place you want to take on 15-30 years worth of debt for.

One option is to skip traditional home mortgages and opt for a construction loan instead.

Construction loans are riskier for lenders and a bit more involved for borrowers as there’s zero collateral at the start. They are, essentially, money for nothing-until-it-eventually-becomes-something. And the actual build process can be quite trying and filled with costly surprises.

However, as with most things, a little bit of homework can get you prepped to take advantage of this out-of-the-box opportunity.


Typically, one of two short-term loans—each about a year—that is specifically to covert the cost of building a home.

Stand-alone construction. After the home is built you’ll need to secure a second, more traditional loan (AKA, the “end loan”) to pay off the construction loan.

Stand-alone construction loans may be more expensive because you’re paying two sets of fees. Plus, you can’t lock in a mortgage rate until after the home is built, so if the prime rate goes up, you’ll pay more in interest on the construction loan and the end loan.

Alternatively, stand-alone construction loans may require lower down payments and are frequently set-up as interest-only loans so you don’t have to pay down the principal before you pay it off in full. As such, they might be easier to swing for the less deep-pocketed when the economy is running steady.

Construction-to-permanent (such as offered by Northpointe). With these, you essentially have two-loans-in-one that offer a single closing, one set of closing costs and an interest rate that is set prior to the close. Even better, the interest rate is the same for both construction and the end loan.


Local and regional banks are more likely to offer these, as the bigger, national chains are much more risk-averse.

Obviously, you’ll need to have a solid credit report, credit score, work history, current income, etc. to even consider this option.

In addition, you’ll need to have the following:

First, sign on with a reputable, licensed general contractor who has a track record of delivering quality homes within your price range and in the style you want. (It will be much more difficult to qualify for this first step if you intend to serve as your own general contractor, especially if this is your first home.)

Second, you’ll need to provide all of the specs for the home. Floor plans, material lists, measurements for all rooms, walls, insulation, window types. The works. This is sometimes referred to as a “blue book.”

Third, an appraiser will have to provide a formal estimate of the home’s value. The appraiser will compare your blue book to other homes in the area (called, “comps”) with similar elements and determine the value accordingly.

Fourth, you’ll have to provide a down payment of at least 20-25%. Anything less, and your lender may not believe you’re actually committed to seeing the build through to the end.


Rather than just dumping a pile of cash into your contractor’s bank account, your lender will set up a schedule of draws.

Draws are predetermined times when a portion of funds become available (e.g. buying the land, pouring the foundation, erecting the framing, etc.). How many draws and how much money will be determined by your timeline and the scope of your project.


If circumstances keep your home from being finished on time or within the budget, you have to continue to pay for a place to stay as well as pay fees or penalties to extend the loan.

It may also happen that your newly built home won’t be worth as much as you borrowed, and you’ll have to find a second mortgage to cover the construction loan.

If you lose your job after construction begins, you may no longer qualify for an end loan. Construction loans must be paid off when the house is built. If you can’t pay, you may end up losing your newly built house and still be in the red.


Construction loans are not for the faint of heart, but if you’ve got the financial wherewithal and the disposition to handle the unexpected, they can be a great way to ensure you end up with exactly the home of your dreams.

On the other hand, if you’re not much of a risk-taker, a more conventional loan may be the safer, less anxious path.