If you’ve never built a house from the ground up before, it can be an intimidating process.
You have to find the land, draw up plans, budget for construction costs, hire a builder, and oh yeah – figure out how to pay for it all!
The normal process of buying a pre-owned or even new construction home is relatively simple in comparison. Almost all lenders are familiar with the process and are able to give you a loan without much hassle.
But what if you are building new? How can you get a loan to build a house?
The Difference Between Construction Loans and Conventional Loans
If you are buying an existing home, there is a robust marketplace for “conforming” loans (those that conform to government-backed Fannie Mae or Freddie Mac guidelines). You can easily get a loan for as little as 3-5% down if you’re willing to pay for private mortgage insurance (PMI). This is a relatively low-risk proposition for the lender, as the existing house is used as collateral for the loan based on the appraised value.
However, if you are building a new home, that is a much riskier bet for the lender. There is no existing property to use as collateral for the loan in case you default, so the lender has a lot more at stake. And they will pass that risk premium along to you, the home builder, in the form of higher interest rates and stricter terms compared to an existing home loan.
Here are some of the main differences between a construction loan and a conventional home loan.
- As little as 3-5% down payment
- Relatively easy to get approved based on credit score and income
- Fixed interest rate for 15-30 years
- Widely available from almost all banks
- 20-30% down payment or more
- Stringent approval process based on acceptance of your builder, construction plans, budget, etc.
- Short term loan (usually <1 year) with variable interest rate
- Usually only available from smaller or regional lenders
What Type of Construction Loan Should I Get?
If you are looking to get a loan to build a house, there are actually a few different types of loans you can use. There are pros and cons to each one, and which is best for your depends on your personal situation.
With a construction-only loan, you will get a short term loan to fund the construction of your new home. You will pay interest on the loan at a variable rate tied to the prime rate, so if the Federal Reserve raises or lowers their guidance interest rates, your rate will change with it.
Once construction is complete, you will then be able to apply for a conventional mortgage like any other home buyer to pay off the construction loan.
The pros of a construction-only loan are that it allows you more flexibility in that you will only have to put a down payment for the construction loan itself, not the permanent loan, and you will be able to shop for a conventional mortgage where you can often put 3-5% down at the end of the process.
However, there are cons as well. You will have two separate closings, one for the construction loan and one for the permanent loan, which increases your closing costs. Also, if your financial situation changes during the construction process (such as a job loss) it could be more difficult or impossible to get a conventional loan when construction is complete.
A construction-to-permanent loan is basically like a construction loan except that you agree in advance to convert it to a permanent loan once the house is complete and a certificate of occupancy is issued. In most cases, you can even lock your long-term interest rate on the permanent loan at the beginning of construction.
During the construction phase, you will most likely have a variable interest rate as you would with a construction-only loan. As the different phases of construction are completed you will take draws from the loan to pay the builder. Once construction is complete, an appraisal will be done and the loan will automatically be converted to a conventional loan.
Many people choose to go with a construction-to-permanent loan because it is a “one-step” loan and you only have to pay for closing costs once. It also allows you to lock in the terms of the permanent loan before construction begins, so you do not have to re-qualify for a loan again in 6-12 months when the house is complete.
The main con of going this route is that most lenders require a 20% down payment, even once it is converted to a permanent loan, so you would have to have to keep your cash tied up in the house after construction. This is not a big deal if you have set aside the money, but if you were hoping to end up with only 3-5% of the value as a down payment at the end of the process, it is less favorable than the construction-only loan.
How to Get a Loan to Build a House (It’s Not That Easy)
If you thought you had to perform financial gymnastics to qualify for a conventional loan, prepare to take it to a whole new level with a construction loan.
Since the lender can’t use an actual house as collateral to secure the loan, they are taking on a lot more risk. To try to reduce that risk, they will scrutinize every part of the process to make sure you have adequate savings, are using a reputable builder, have a realistic budget, and the income to make monthly loan payments while you are still living in your current home.
1. Choosing a Builder
Apart from qualifying for a loan, choosing the builder is quite possibly the most important part of your new home construction process. You want to make sure you vet them carefully and get references from other people, tour houses they have under construction etc.
The lender will want to see detailed financials on not just you, but on your builder. Have they built other houses like yours? Do they have the correct licenses? Are they in good financial standing? Has the lender worked with this builder before?
Once you choose a builder, if they are reputable and have done many construction projects similar to yours, they may already have a relationship with a lender that trusts them and their work. If that is the case, using the builder’s preferred lender could streamline the process. But make sure you shop around to make sure you are getting the best rate and terms. It may be worth a little extra pain during the initial qualification if you can get a lower interest rate or simpler loan structure.
2. Approving the Building Plans
Once you’ve chosen a builder, you will need to work with them to get the design plans and budget drawn up. The lender will require a comprehensive plan that includes the floor plans, materials used, and construction cost estimates before they will sign off on the loan.
The lender will also require an appraisal be done to verify the value of the home once it is built. You need to consider the location and type of house you will be building. If you want to build a 6,000 square foot mansion in the middle of a neighborhood of 1,200 square foot houses, it may be difficult to obtain an appraisal that will meet the construction costs of the house. The appraiser will need to use comparable homes (“comps”) to determine your new home’s value. If it’s less than the construction costs, you’ll either have to come up with more cash or find a way to reduce the construction budget.
3. Your Credit and Financial Stability
With a conventional loan, the lender uses guidelines set by Fannie Mae to look at your debt-to-income ratios, overall income, and savings for a down payment. Everything is pretty standard and most lenders will treat you the same way.
However, if you want to get a loan to build a house, there are no set guidelines. Each bank may look at your situation differently. But the basic principles still apply. You will need good credit, ability to pay (adequate debt-to-income ratio), and enough in savings to both cover a down payment and reserves in case the project runs over budget.
Things can and do go wrong during construction, and you will need to be prepared with contingency funds if things go over budget.
How a Construction Loan Works
Once you jump through all the hoops to qualify for a loan to build a house, then you will close on the loan and the real fun begins!
Generally, the construction loan is set up to pay the builder in increments called draws. This protects both you the owner and the bank. The loan should have specific milestones set up for the builder to complete before a draw is requested.
The bank will then send out an inspector to verify that the agreed upon work has been completed for that phase of the construction, and they will release a draw to pay the builder.
One nice thing about this process is that a construction loan is an interest-only loan, and you are only paying interest on the money that has been loaned out. So if the total construction loan is for $200,000, you may have 4 draws of $50,000 each. So after the first draw, you are only paying interest on $50,000, then after the second draw you’re paying interest on $100,000, and so on.
My Construction Loan Story
While I have never built a house from the ground up, I do have experience with extensive rehab projects. When we first got started flipping houses, we didn’t have much in the bank so we had to figure out how to invest in real estate with no money.
One way we did that was to leverage a construction loan from a local bank, so we only had to put up the down payment and the bank covered the rest of the house plus the additional construction costs.
Our first flip we bought for $100,000 and it needed about $40,000 in work. I think we were able to get a loan from the bank for $120,000 (so we put $20,000 down), and the $40,000 was held in escrow to pay for construction costs in 2 separate draws. This was a few years ago, but we were able to get a 7.5% variable interest rate.
This was the first construction loan we’d ever applied for, and I was not prepared for the level of documentation that would be required. We had to fill out a full personal net worth statement showing all of our assets, liabilities, income, and cash flow in excruciating detail. We also had to provide our contractor’s credentials and a full budget for the rehab.
Once we got through the qualification process, it was actually a fairly smooth construction project. We did have one hiccup in that getting the first requested draw took a long time so we had to come out of pocket to pay the contractor until we could get reimbursed from the draw. We were slightly over budget (I can’t say I’ve ever come in under budget on a rehab), but overall the construction loan process helped us to do a project we otherwise didn’t have the cash to complete, so it was a win!
Once the house was complete, we debated whether we should sell and lock in our profits or try to convert the construction loan into a conventional loan and keep it as a rental. It met the 1% rule of rental properties, which means that the monthly rents would have been a little more than 1% of the amount of money we had in the house. So it would have cash flowed a little bit every month after expenses.
Ultimately, we decided to sell for around $190,000 and used our profits for a down payment on another rental house that was slightly less expensive, which was the beginning of our rental property portfolio.
While there are a ton of side hustles you can do to make extra money, real estate has been a great one for us because it allows you to take advantage of leverage. On almost all of our properties, we have taken out a construction loan because the house was in such disrepair it wouldn’t qualify for a normal loan. Once we fixed it up, we were able to convert it into a conventional mortgage. It has been a great tool for us to build equity without having to put up the cash ourselves!
How to Get a Loan to Build a House – Final Thoughts
Whether you are building your dream home, a spec home, or rehabbing a dilapidated property, getting a construction loan to build a house is an important part of the process if you don’t have a few hundred thousand dollars sitting around.
Going into it fully aware of the process of qualifying for a construction loan puts you ahead of the game. As long as you are prepared for the challenges and risks of building a home, it can be a very rewarding experience.
To recap, here are the main steps in getting a loan to build a house:
- Determine what type of loan you need (construction-only or construction-to-permanent).
- Choose a reputable builder who can provide blueprints, budgets, and any other info the bank might need about the construction process.
- Interview lenders to find the one with the best rates and terms.
- Be prepared for the unexpected with a sizable emergency fund. Not having extra cash on hand is a huge risk!
- Work with the lender and the builder throughout the construction process to make sure the builder is doing quality work and meeting the lender’s milestones, and that the lender is making timely draw payments per the schedule.
- Once construction is complete, depending on the type of construction loan you took out, you can either automatically convert it to a conventional loan and pay off the construction loan, or re-qualify for a conventional loan based on the value of your new house to pay back the construction loan.
Andrew writes about all things personal finance, and has a passion for helping people pursue financial freedom through saving money, making money, and building wealth.
He documents his family’s journey to financial independence through side hustles (while raising two kids on a single income) at his blog, Wealthy Nickel.