With a construction loan, you get a way to get the money you need to create your own new-build home. These loans usually pay out as the project moves forward, making cash available as you need it while protecting the lender. Still, lenders see them as higher-risk than a traditional mortgage, and usually charge more in interest as a result. 

Using a loan to finance constructing your home

Mortgages are an established type of loan: you use them to buy an existing property. They’re also a secured loan, meaning that the house secures the amount of money you borrow from the lender. In other words, if you stop repaying your mortgage, the lender can take your house and sell it to make up for their losses. 

How do you go about it, then, if the home you’d usually use to secure the loan doesn’t exist yet? Enter: construction loans.

Specifically designed to cover the cost of construction, these loans usually have a short repayment term. One year is common. And instead of paying out a lump sum all at once, construction loans usually release funds as milestones get hit on the project. In most cases, that money goes directly to your general contractor (GC) rather than flowing through you. 

You can use a construction loan to cover the cost of the property you want to buy to build on (i.e., the land), plus labor and materials. It can usually be applied to permitting costs, too. 

Be aware, though, that a construction loan often can’t be used for design costs. If you want to work with an architect or design firm, you’ll usually need to pay for that out of pocket. 

Getting a construction loan

Qualifying for a construction loan is generally more challenging than qualifying for a mortgage. 

With no existing home to serve as collateral, these loans are riskier for lenders. Add in all of the uncertainties that come with construction, including the commonness of delays. That’s led to lenders charging a higher interest rate and requiring a bigger down payment. You’ll usually need to put at least 20% down to get a construction loan. You’ll need a solid credit score and consistent income, too.

Also, lenders will want to see your plan for the construction itself. You’ll usually need to use a licensed building and hand over all of your contract documents, including drawings (also called blueprints) and specifications. The lender uses this information to decide how much to lend you and at what interest rate.

They also use your construction documents to set milestones for the project. You won’t get more money from them until you hit each of those milestones. 

Even if you can tick all of these boxes, you still need to find a construction loan lender. Not all mortgage companies offer this type of financing. 

Local banks and credit unions are a good place to start looking. Their knowledge of your local housing market makes them more likely to offer this kind of loan. 

You can also explore government-backed construction loans, including:

• The Construction to Permanent (CP) and Building on Own Land (BOOL) programs from the Federal Housing Administration (FHA)
• The Combination Construction-to-Permanent (Single Close) Loan program from the U.S. Department of Agriculture (USDA)
• One-Time and Two-Time Close Construction Loans from the Department of Veterans Affairs (VA)

These federally backed options can make a construction loan more affordable for eligible would-be builders. Because of the governmental guarantee behind them, they often come with lower interest rates and down payments than other construction loans. 

How a construction loan works, including interest and repayment

During the construction loan term, your lender monitors the project’s progress. As you hit predetermined milestones (e.g., your foundation is poured or your drywall is hung), it triggers a draw. At that point, the lender disburses a new batch of funds to your GC to keep the project moving forward. A lot of construction loans have a handful of draws (e.g., 4–6) planned during the loan term. 

Usually, a construction loan is an interest-only loan that comes with a variable interest rate. That means that while construction is ongoing, you only need to pay off the interest that’s accrued on what’s been drawn so far. But the rate on that can shift up or down depending on the market. 

If you want to get a feel for the kind of construction loan interest rates available today, check out our rate table. 

Once construction is completed — usually, once the certificate of occupancy is issued — things change. 

What happens when construction is complete

You can get a construction-only loan, which functions as standalone financing for your home build. With this option, the full loan balance comes due once construction is complete. At that point, most people take out a mortgage on the house and use that to repay what they owe. In this case, the mortgage is also called an end loan. 

Alternatively, you can get a construction-to-permanent loan, also called a one-time close or single-close loan. This kind of financing converts your construction loan balance into a mortgage once construction is complete. Once that conversion is done, the resulting mortgage usually has the features you’d expect, like a 15 or 30-year repayment term and a fixed interest rate. 

When you choose a construction-to-permanent loan, you don’t have to pay two sets of closing costs: one for the construction-only loan and one for the mortgage. This can help you save money. Plus, it guarantees that you can finance your home. If you wait to get a mortgage until after construction and your financial situation changes for the worse, you could have trouble securing a loan. 

If you’ve always dreamed of building your own house, a construction loan can help you buy the land, hire the contractor, and pay for the materials and labor. It’s important, though, to understand how you’ll manage the interest payments while construction is ongoing. And it’s just as important, if not moreso, to have a plan to pay off the balance once the project is complete. That means either converting it through a construction-to-permanent loan or taking out an end loan.

Planning for the financial side of all of this gets easier when you know what to expect in terms of interest rates. Get a feel for the current rate environment today.