The idea of building a home that meets all your needs is something a lot of people fantasize about. Maybe you’re already a homeowner and the goal is an accessory dwelling unit—a granny flat, tiny house on a foundation, carriage house, garage apartment, or basement apartment.
Maybe you’ve found a fixer-upper on a perfect plot of land. Or maybe you’ve got a perfect piece of land, and all you need now is the house.
A construction loan could be just the ticket, though a borrower should be aware of the complications of these kinds of loans.
Here’s a look at construction loans and a couple of alternatives.
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How Do Construction Loans Work?
Construction loans finance the building of a new home or substantial renovations to a current home.
They are typically short-term, variable interest rate loans designed to cover the costs of land, plans, permits and fees, labor, materials, and closing costs. They also cover contingency reserves if construction goes over budget.
When you buy a house, you can finance it with a mortgage. But when you build a house or do a major renovation, getting financing is trickier. Borrowing large sums of money can be difficult when there’s no collateral to guarantee the loan. The lender probably will want to check out the builder in addition to vetting your financial situation.
Recommended: Preparing Your Budget for Future Home Renovations
Popular Home Construction Loan Options
Sometimes referred to as “single-close” loans, these are construction loans that convert to a mortgage once the construction is finished.
The borrower typically pays interest-only during construction. When the loan is converted to a standard mortgage, the payments are sometimes recast.
The borrower saves money on closing costs by eliminating a second loan closing.
Also called a standalone construction loan, this loan must be paid off when the building is complete. You will need to apply for a mortgage if you don’t have the cash to do so.
Having separate construction and mortgage loans allows homeowners to shop for the best terms available when applying for each loan, but they will pay closing costs with each loan.
Renovation Construction Loans
These are specifically designed to cover the cost of substantial renovations (or the cost of improving a fixer-upper). The loans get folded into the mortgage once the project is complete.
Once you are approved for a construction loan, you are put on what’s called a “draw schedule,” based on your construction timeline. Funds will be disbursed directly to your builder to cover the cost of each stage of construction—usually, after a lender representative pays a visit to make sure everything’s on schedule.
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What Are the Requirements for a Construction Loan?
It’s typically harder to get a construction loan than it is to secure a mortgage. Some people even hire construction loan brokers to facilitate the process. Because your house or ADU isn’t built yet, there’s no collateral. And because there’s no collateral, lenders will want to see strong evidence that the home will be completed.
If it’s a renovation, the lender wants to see that the project will add to the value of the home. Check out SoFi’s Home Project Value Estimator to get an idea of how much value you could get in return for each renovation project.
In order to get approved, you’ll have to show your potential lender an overview of your financial profile, with plenty of documentation. They’ll typically want to see a debt-to-income ratio of 45% or lower and a high credit score.
For new construction projects, they’ll also want you to be able to make a down payment of up to 30%. And for construction-only loans, they may want to know what your repayment plan is—that is, whether you will pay in cash or refinance when the project is complete.
In addition, the lender will want a detailed plan, budget, and schedule for the construction. Some lenders will also need to approve your builder. Because the project will depend on the builder’s ability to complete the construction to specifications, your builder’s reputation may be crucial to getting a construction loan approved.
Lenders typically need to see a builder’s work history, proof of insurance, blueprints, and specifications for the project, a materials list, and your signed construction contract.
What Are the Average Interest Rates and Terms?
Typically, construction loan rates rise and fall with the prime lending rate, but they tend to be higher than conventional mortgage rates.
The terms also vary. A construction-only loan usually must be paid off in one year or less, unless the homeowner obtains a mortgage to secure longer-term financing.
A construction-to-permanent loan will typically have a term of 15 to 30 years once it becomes a permanent mortgage. Again, though, the interest rate will usually be higher than a conventional loan because of the increased risk. The longer the term, the higher the rate tends to be.
Are There Alternatives to Construction Loans?
A lot of time and effort may go into securing a construction loan. It can be difficult to find lenders that offer competitive rates and qualify for them—particularly if you don’t have a flawless credit history. Two alternatives are a personal loan and a cash-out refinance.
Plus, they tend to be complicated because it is often the builder who has to carry the loan.
If you are planning a small construction project or renovation, there are a few financing alternatives that might be easier to access and give you more flexibility.
Personal Loans for Renovations
A personal loan can fund a renovation project or supplement other construction financing. It can be much faster and easier to secure than a construction loan.
A home improvement loan also may cost less in interest than a construction loan, depending on your financial profile. And you can frequently choose a personal loan with a fixed interest rate.
Personal loans also offer potentially better terms. Instead of being required to pay off the loan as soon as the home is finished, you can opt for a longer repayment period.
The drawbacks? You won’t be able to roll your personal loan into a mortgage once your renovation or building project is finished.
And because the loan is disbursed all at once, you will have to parse out the money yourself, instead of depending on the lender to finance the build in stages.
Cash-Out Refinance for Construction Costs
A cash-out refinance is also a good financing tool, particularly if you have a lot of equity in your current home. With a cash-out refinance, you refinance your home for more than you owe and are given the difference in cash.
To use a cash-out refinance to cover the cost of construction, you can estimate your building or renovation expenses with this Home Improvement Cost Calculator and then refinance for that amount more than you owe on your home. Then you can put the additional cash from the refinance toward the building project.
Using one—or both—of these alternative financing tools may help you avoid some of the hassle and expense that come with construction loans.
Planning a new home, granny flat, or substantial renovation? A construction loan may be the ticket, though these kinds of loans are usually harder to secure than mortgages, often carry a higher rate, and are typically short-term. For smaller projects, a personal loan or cash-out refinance could be a good option.
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