Unlike a mortgage loan where the entire amount of the loan is disbursed to the borrower at the time the loan transaction is consummated, a construction loan involves a series of disbursements, which are linked to a construction schedule.
What is a construction loan?
A home construction loan is a short-term, higher-interest loan that provides the funds required to build a residential property. Construction loans typically are one year in duration. During this time, the property must be built, and a certificate of occupancy should be issued.
Differences between construction loans and traditional mortgages
Beyond the cost and repayment timeline, construction loans and mortgages have a few main differences:
Loan Money Distribution - Unlike mortgages and personal loans that make a lump-sum payment, the lender pays out the money for a construction loan in stages as work on the new home progresses. These draws tend to happen when major milestones are completed — for example, when the foundation is laid, or the framing of the house begins.
Money the Borrower Owes - With a mortgage, you start paying principal and interest right away. With construction loans, you will typically be expected to make only interest payments during the construction stage. Additionally, borrowers are typically only obligated to repay interest on any funds drawn to date until construction is completed.
Inspection/Appraiser Involvement - While the home is being built, the lender has an appraiser or inspector check the house during the various stages of construction. If approved by the appraiser, the lender makes additional payments to the contractor, known as draws. Expect to have between four and six inspections to monitor the progress.
Types of construction loans
Construction-to-permanent loan - With a construction-to-permanent loan, you borrow money to pay for the cost of building your home, and once the house is complete and you move in, the loan is converted to a permanent mortgage.
Construction-only loan - A construction-only loan provides the funds necessary to complete the building of the home, but the borrower is responsible for either paying the loan in full at maturity (typically one year or less) or obtaining a mortgage to secure permanent financing.
Renovation loan - A home renovation loan is a loan that includes funds for renovating, remodeling, and repairing a home. It’s often a mortgage with extra money for home improvements.
Owner-builder construction loan - Owner-builder loans are construction-to-permanent or construction-only loans where the borrower also acts in the capacity of the home builder.