What Are Construction Loans and How Do They Work?

Jamie Ayala

Jamie Ayala

Jamie Ayala has been working as a Loan Processor at Rock Mortgage for more than 4 years. As a knowledgeable account executive he has had many years of customer service experience in the loan, information technology, and political industries. Recognized for demonstrating a natural aptitude for working with cross-functional teams, as well as for meeting deadlines and validating loan documents, Jamie has a verifyable history of consistently exceeded sales and performance goals. His professional focal points include loan processing, client negotiations, team collaboration, and project management.
What Are Construction Loans and How Do They Work?

If you have a glorious vision for your next home, it might be best to simply build it yourself. While this process can be rewarding, it’s also expensive, and it can be hard to find the necessary funds for labor and materials. Fortunately, many lenders offer private construction loans to help you build your dream house and spread out the cost. 

At Rock Mortgage, we’re here to help you understand what construction loans are and how they work. Keep reading to learn more about these loans and find out whether they’re right for you.

What Is a Construction Loan?

A construction loan is a sum of money that you can use to cover the cost of building a residential property. These loans can be used to pay for materials, labor, contracting services, and even land. There are several different types of construction loans, including:

Construction-only Loan

A construction-only loan is a short-term adjustable rate loan that can be used to build a home or complete construction on one. The loan typically lasts as long as construction, and once the residence is complete, the full loan amount is due. Alternatively, the borrower can refinance the loan into a mortgage.

Renovation Loan

A renovation loan can cover the costs of major expansions or improvements to a home. This is best if you’re planning to add a garage, pool, or extra room and is similar to a traditional mortgage. The loan amount is generated based on the final value of the home once the renovation is complete. 

If you’re buying a house that needs a lot of work, this might be the right choice. A slight variation of this is a rehabilitation loan, which covers the costs of making a building fit for habitation.

Owner-builder Construction Loan

Owner-builder loans are intended for professional construction contractors who want to build their own homes. If this sounds like you, consider an owner-builder loan. In order to qualify, you’ll have to provide your professional certifications.

Construction-to-Permanent Loan

These loans are structured so that they transition into a traditional mortgage as soon as construction is complete. This model streamlines the process of getting a mortgage and can help homeowners lock in their mortgage rates and save time and money.

How Do Home Construction Loans Work?

Construction loans work much differently than other types of loans you might be used to. When you apply for a construction loan, you’ll probably have to submit a construction plan and schedule. While the home is being built, you’ll make interest payments, and the loan will act much like a line of credit. 

As soon as you complete a certain phase of construction, there will be a “draw” on the loan that will go to paying the contractors. Instead of you receiving the entire lump sum at once, the contractors will receive loan funds in segments as the project progresses.

How To Get a Construction Loan

Applying for a construction loan is often more involved than applying for other types of loans. You’ll need to submit some additional materials to the lender so that they can validate your plans and allocate funds on the right timetable. Although terms will vary by lender, these are the basic requirements for getting a construction loan:

  • Adequate income: The lender will verify that you have enough income to pay off the loan once construction ends. To demonstrate your income, you may have to submit pay stubs, bank statements, and other documents.
  • Good credit: If you don’t have good credit, it’s going to be pretty hard to get a construction loan. Most companies will look for a credit score of at least 680, and some may look for a score over 700.
  • A down payment: Construction loans generally require a hefty down payment of at least 20%. The exact fraction will depend on the lender and your credit history.
  • Project documentation: As we mentioned before, your lender will want to know as much as possible about your plans before approving you for a loan. It’s important to provide construction contracts, blueprints, itemized budgets, and a complete construction schedule to arrange draws.
  • Contractor approval: Your lender will have to verify that you’re working with certified contractors during your project. They may ask you for their licenses, resumes, and insurance documents, as well as an overview of their responsibilities.

That’s a quick overview of construction loans and how they work. If you’re ready to build your dream house, we hope you’ll consider Rock Mortgage. Good luck with your projects and we hope to see you soon.