Construction Mortgage: What It Is, How It Works, How to Apply

What Is a Construction Mortgage?

A construction mortgage is a type of loan that finances the building of a home specifically. The money loaned is often advanced incrementally during the building phase as the work progresses. Typically, the mortgage only requires payment of interest during the construction period. When the building phase is over, the loan amount comes due—though some construction mortgages can roll over into standard mortgages.

How a Construction Mortgage Works

Though a traditional mortgage will help you buy an existing residence, building from the ground up—starting with raw land, that is—requires a construction mortgage, aka a construction loan.

When it comes to construction, unforeseen expenses commonly arise, increasing the overall costs. Construction mortgages may be sought as a way to better ensure that most—if not all—building costs are covered on time, preventing delays in the completion of the home.

Because a new home project is riskier than buying an existing residence, construction mortgages can be more difficult to obtain and carry higher rates than regular home mortgages. Still, there are plenty of lenders out there—both specialists in home loans and traditional banks.

Lenders may offer different options to make construction mortgages more attractive to borrowers. This could include interest-only payments during the construction phase, and for construction-to-permanent loans, they might also offer locked-in interest rates when construction begins.

Construction-to-Permanent vs. Stand-Alone Construction Loans

The two most popular types of construction mortgages are stand-alone construction loans and construction-to-permanent loans.

A construction-to-permanent loan is a construction loan that converts to a permanent mortgage when the building is completed. Technically, the financing option has two parts: a loan to cover the costs of construction and a mortgage on the finished home. The advantage of such plans is that you have to apply only once, and you will have only one loan closing.

If the borrower does not take out a construction-to-permanent loan, they could make use of a stand-alone construction loan, which typically has a one-year maximum term. Such a construction mortgage might call for a smaller down payment.

The interest rate cannot be locked in on a stand-alone construction mortgage. The base interest rates might also be higher than a construction-to-permanent loan.

The borrower may need to apply for a separate mortgage to pay for the construction mortgage debt, which would be due after completion. The borrower can sell their existing home and live in a rental or another type of housing during the construction of the new residence.

That would allow them to use equity from the sale of their previous home to cover any costs after the creation of the new house, meaning the construction mortgage would be the only outstanding debt.

How to Apply for a Construction Loan

Applying for a construction loan is in some ways similar to applying for any mortgage—the process includes a review of the borrower’s debts, assets, and income. (So, be ready to furnish financial statements, tax returns, W-2s, and credit reports.) But it involves more.

To qualify for a construction mortgage, the borrower must also have a signed purchase or construction contract with the builder or developer.

This agreement should include many facts and figures, such as the overall project timeline (including the start and expected completion dates), as well as the overall contract amount, which provides for all the estimated costs of construction and, if applicable, the cost of the land or property itself.

Architectural drawings, detailed floor plans, and a breakdown of building materials—in short, a comprehensive list that helps account for the budget—are typically part of the package.

Your building contractor or construction company will need to provide financial statements as well as current license and insurance documentation.

At a minimum, most lenders require a 20% down payment for a construction mortgage (some require as much as 30%). That's not so different than the requirements for many conventional mortgages.

But along with your creditworthiness, lenders are often interested in your liquidity. They might expect a certain amount of cash set aside in case building costs end up being higher than expected. And if you're opting for a stand-alone construction loan, remember that it's pretty short-term—and when the year's up, you better be either ready to repay or in a position to qualify for new financing.

The Bottom Line

If you're looking to build a home from the ground up as opposed to buying one already made, you will need a construction loan to finance the house. Funds are generally released in installments as the construction moves from one phase to the next. Upon completion of the house, your loan can turn into a standard mortgage.