Construction Loans: What's Covered And What's Not?

Construction loans are a type of short-term financing that can be used to cover the costs of building a custom home. These loans differ from traditional mortgages and are meant to cover expenses associated with construction, such as contractor fees, labour, permits, and the cost of the land itself. They are typically converted into a conventional mortgage once the construction is complete. This guide will provide an overview of what construction loans cover, the application process, and how they differ from traditional mortgages.

Construction loan vs. mortgage loan

Construction loans and mortgage loans are the two primary financing options for a new home. They differ in the houses they cover, when you can use the money, requirements to receive them, and how long they last.

A construction loan is a short-term loan that covers the costs of custom home building. It is a specialty financing option for people who want to build a home instead of buying one that's already built. It covers the total cost of building a home, including the land, labour, materials, permits, and major home appliances. The initial term of a construction loan is generally a year or less, during which the borrower must finish the project and pay interest on the money drawn. After the construction is complete, the borrower must pay off the loan with a lump sum or convert it to a conventional mortgage loan.

A mortgage loan, on the other hand, is a long-term financing option for homes that are already constructed. It is used to purchase a home and is often secured by the home being purchased. The repayment terms for mortgage loans are usually longer, ranging from 15 to 30 years. With a mortgage, the borrower receives the money in one lump sum, and the payments start immediately, consisting of both principal and interest.

The approval process for a construction loan can be more rigorous than for a mortgage loan. For a construction loan, the lender typically disburses funds at the completion of each phase of construction or as additional funds are needed, whereas a mortgage loan is paid out upfront, covering the entire cost of the home. Construction loans may require higher interest rates and larger down payments due to the risk involved, as there is no finished product to serve as collateral.

What construction loans cover

Construction loans are short-term loans that cover the costs of building a home. They are different from traditional mortgages and are considered specialty financing. Construction loans are intended for a specific set of future homeowners who have decided to build a home instead of buying one that's already built.

Construction loans can be used to cover the costs of buying land, hiring a contractor, and purchasing building materials. They can also be used to pay for plans, permits, and fees associated with building a home, such as building permit fees, environmental impact assessment fees, water and sewage fee inspections, and other architecture and engineering assessment fees. The NAHB estimates that permits cost around $18,323 on average.

Construction loans also cover the costs of labour and inspections. They can also provide funds to cover interest payments during the building of your home. Major home appliances, such as refrigerators, washers, and dryers, are also covered by construction loans.

Construction loans do not cover the costs of designing your home. If you want to hire a professional architect or interior designer, you will need to cover those costs yourself. Construction loans also do not cover home furnishings, such as furniture and decor.

It is important to note that construction loans have a shorter term, usually about one year, which is the length of time most new home constructions are expected to take. After the construction is complete, the loan is typically converted into a conventional mortgage, and the borrower begins to make payments on the principal and interest.

What construction loans don't cover

Construction loans are a great way to finance the construction of your dream home. They cover a wide range of expenses, from the cost of land to labour and materials. However, it's important to understand that construction loans don't cover every expense involved in building a new home. Here are some things that construction loans typically don't cover:

Design Costs

Construction loans usually do not include design costs. If you plan to hire a professional architect or interior designer to create your dream home, you will need to budget for these expenses separately. This includes any fees associated with creating detailed floor plans, 3D renderings, or other design services.

Home Furnishings and Décor

While construction loans cover major home appliances such as refrigerators, freezers, washers, dryers, and dishwashers, they do not extend to home furnishings and décor. This means that furniture, such as couches, dining tables, bedroom sets, and decorative items, will need to be purchased separately and are not covered by the loan.

Living Expenses during Construction

Construction loans are intended solely for the costs of construction. They do not cover your living expenses during the construction period. Therefore, you will need to budget for rent or temporary housing while your new home is being built. This can be a significant financial burden, especially if you are also paying off an existing mortgage or lease.

Closing Costs for Permanent Mortgage

After the construction is complete, your construction loan will likely be converted into a traditional mortgage. However, the closing costs associated with this permanent mortgage are typically not covered by the construction loan. These closing costs can include fees such as loan origination fees, appraisal fees, and other settlement fees.

Overruns and Unforeseen Costs

While construction loans provide financing for the expected costs of construction, they may not cover all unforeseen expenses. Construction projects can sometimes encounter unexpected issues or delays, resulting in additional costs. These might include problems with the land, unexpected permit requirements, or changes in material prices. It is important to have some financial buffer to account for these potential overruns, as they are generally not covered by construction loans.

Applying for a construction loan

Construction loans are a type of short-term financing that covers the costs of building a home. They are usually issued for a year or less, and are meant to cover only the actual construction period. They are similar to mortgages but differ in substantial ways.

If you're building a home from scratch, a construction loan could be a good option for you. Here are some steps to follow when applying for a construction loan:

Understand the Basics of Construction Loans

Before applying for a construction loan, it's important to understand how they work. Construction loans are typically short-term loans with a duration of a year or less. They are used to cover the costs of building a home, including the land, labour, materials, and permits. Unlike a traditional mortgage, construction loans usually involve making interest-only payments during the construction phase, and the funds are released in stages based on the project's progress.

Compare Rates and Lenders

Construction loans can be more expensive than traditional mortgages, so it's important to shop around and compare rates from different lenders. Consider both conventional loans and government-backed options, such as FHA construction-to-permanent loans or VA construction loans for eligible veterans.

Prepare the Necessary Documentation

The approval process for a construction loan is similar to that of a typical mortgage. You will need to submit documentation to the lender, including financial information, credit score, income, and assets. Additionally, you may need to provide a signed construction contract with your builder, detailing the construction costs, start and completion dates, and other relevant information.

Provide a Detailed Construction Plan

Lenders will typically require a construction timeline, detailed plans, and a realistic budget. This information will help the lender understand the scope and cost of your project and determine the release of funds at various phases of construction.

Understand the Draw Schedule

Once your loan is approved, you will work with the lender to create a draw schedule, which is a detailed payment plan outlining how funds will be disbursed as the construction project progresses. This ensures that funds are released in conjunction with each phase of construction.

Be Prepared for Inspections

Throughout the construction process, an appraiser or inspector will check in on the build to ensure that the project is on track and that the borrower can continue to have access to funds. These inspections are standard practice and help protect both the lender and the borrower.

Expect a Conversion to a Traditional Mortgage

After the construction is complete, your construction loan will likely be converted into a traditional mortgage, at which point you will begin making payments on the principal and interest. This is known as a construction-to-permanent loan, and it offers the benefit of having only one set of closing costs, reducing your overall expenses.

By following these steps and working closely with your chosen lender, you can successfully apply for a construction loan to turn your dream home into a reality.

Construction loan repayment

Construction loans are typically short-term loans that cover the costs of building a home. They are often used to finance the construction of commercial or residential real estate. The loan applicant may be a real estate developer or an individual building a custom house. Construction loans are usually for a year or less, after which the loan is replaced by a long-term mortgage financing plan.

During the construction loan phase, borrowers are only responsible for making interest payments on the money they have drawn. The principal amount is not repaid until the construction is completed. The lender will make payments to the borrower or directly to the contractor in instalments as the project completes new stages of development. These instalments are based on a pre-agreed drawdown schedule and are usually released after an inspection of the completed work.

After the construction is complete, the borrower will be issued a certificate of occupancy, and the construction loan will be converted into a traditional mortgage. At this point, the borrower will begin to make payments on the principal and interest. The construction loan may be folded into a permanent mortgage with the same lender or used to obtain a new loan to pay off the construction loan (also known as an "end loan").

It is important to note that construction loans have higher interest rates than traditional mortgages, and the monthly payments can fluctuate based on rate changes. Additionally, construction loans have tougher credit requirements and usually require a minimum down payment of 20-25%.

Frequently asked questions