What Is a Construction Mortgage?

Construction Mortgage Explained in Less Than 5 Minutes

Two construction workers review plans.
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DEFINITION
A construction mortgage is a short-term loan product that covers the cost of building a home. It can either be paid at the end of the loan term, or converted into a traditional mortgage.

A construction mortgage is a short-term loan product that covers the cost of building a home. It can either be paid at the end of the loan term, or converted into a traditional mortgage. Because there is more lender risk, construction mortgages usually have stricter qualifications and higher interest rates.

Find out more about how construction mortgages work, the two main types, and what you’ll need to qualify for one.

Definition and Examples of a Construction Mortgage

A construction mortgage is a specific kind of short-term home loan program that funds the cost of building a home. It can convert into a regular mortgage after a set amount of time, or it can be a construction-only loan that comes due once the project is complete.

  • Alternate name: Construction loan

A construction mortgage is most commonly used by someone who wants a new-construction home and needs funds to pay the builders as they complete each phase of construction. Or it could be used to hire a contractor to construct a new home on property or renovate an existing home.

How Does a Construction Mortgage Work?

A construction mortgage works a bit differently than a regular home loan. For starters, they are shorter term, and typically have higher interest rates than traditional long-term mortgages.

With a construction mortgage, you don’t get the entire amount of the loan at once. Instead, the construction mortgage lender, along with you and the builder, agree upon a schedule in which the lender will disburse funds directly to the contractor during the building process. This is called the draw schedule.

These funds are used for the construction of the structure of the home as well as for permanent fixtures. After each phase, the progress will be verified with an inspection, and the title will be updated before the lender releases the next payment.

During the construction phase, the borrower makes interest-only payments. In some cases, payments will not have to begin until six to 24 months after the loan is made.

Once the project is complete, the next steps depend on the type of construction mortgage. For stand-alone construction loans, the borrower will have to pay the loan, which is usually done via refinance.

For construction-to-permanent mortgages, the loan will convert to a traditional mortgage in which principal and interest payments are due monthly.

Types of Construction Mortgages

There are two main types of construction mortgages. Stand-alone requires two separate loan closings. Construction-to-permanent, which starts out as a construction loan and converts to a regular mortgage upon building completion, requires only one closing.

Whether a single-close or two-close construction loan is best for you will depend on your personal situation; they each have their pros and cons.

Stand-alone Construction Loan

Some borrowers prefer to go with a two-closing transaction. In other words, they’ll start out by applying for a short-term construction loan that covers the funds needed for the building, then apply for a new-home mortgage afterward.

A two-closing transaction can provide you with more flexibility and time to shop for better interest rates for your mortgage than one offered by the lender providing a construction mortgage.

Construction-to-Permanent Mortgage

A construction-to-permanent mortgage is a single-closing transaction, meaning it only involves one application process and one closing. Once approved, you’ll be all set with financing for the build, as well as for the completed home.

While it’s being constructed, you'll only have to pay interest on the construction loan portion of the mortgage.

After the structure is completed and move-in ready, you’ll get the certificate of occupancy and the loan will convert to a permanent mortgage. That's when you’ll begin making regular principal and interest monthly payments.

The key advantages of this unified approach are that you only have to pay one set of closing costs, and you don’t have to go through two separate application processes.

Think you have the skills to build your own home? Unfortunately, contractors or builders who are constructing their own residence are not eligible for construction-to-permanent loans.

How To Get a Construction Mortgage

Because there’s no physical home to serve as collateral when you apply for a construction mortgage, the lender is taking on a lot more risk. For that reason, you can expect that interest rates will likely be higher and borrowing requirements will be more stringent than a regular home purchase loan would be.

Some factors to consider in getting a construction mortgage include:

  • More money down: While it’s possible to get a regular home loan with as little as 3% down, for construction loans, expect to put up a lot more cash. Usually, lenders will require a 20% to 25% down payment.
  • Stronger credit scores: For some construction loans, you may need a minimum credit score as high as 700, which is generally higher than what most other standard mortgages require.
  • Builder reputation: In addition to the borrower being eligible, with a construction loan, the builder must also get approved by the lender. For construction financing, lenders require you to work with a contractor who is licensed by the state, has two or more years experience, carries ample liability insurance, has an acceptable credit history, and no criminal record.

It is possible to get a construction loan with less rigid credit requirements and a lower down payment. The FHA’s construction-to-permanent loan is designed for such borrowers. However, be sure to consider the other layers of eligibility involved.

Key Takeaways

  • Construction mortgages allow you to pay for the cost of custom building a new home.
  • With construction mortgages, you can expect a higher down payment, more stringent credit score requirements, and shorter terms.
  • There are two main types of construction mortgages: stand-alone construction loans and construction-to-permanent loans.
  • Qualifying for a construction mortgage involves not only meeting the lender’s borrower standards, but getting your builder approved.

Article Sources

  1. TD Bank. “New Home Construction Loans and Mortgage Financing.” Accessed Dec. 17, 2021.

  2. Consumer Financial Protection Bureau. “What Is a Construction Loan?” Accessed Dec. 17, 2021.

  3. Fannie Mae. “Construction Products.” Accessed Dec. 17, 2021.

  4. Truliant Federal Credit Union. “Understanding Construction Loan Requirements.” Accessed Dec. 17, 2021.

  5. Rocket Mortgage. “Construction Loans: What You Need To Know.” Accessed Dec. 17, 2021.

  6. Fannie Mae. “Construction-to-Permanent Financing: Single-Closing Transactions.” Accessed Dec. 17, 2021.

  7. Fannie Mae. “Eligibility Matrix.” Accessed Dec. 17, 2021.

  8. Cornell Legal Information Institute. “Combination Construction and Permanent Loans.” Accessed Dec. 17, 2021.