Using Construction Loans for Homebuilding and Renovations

The idea of building a home that meets all your needs is something a lot of people fantasize about—especially if they’ve been house hunting for a long time. A home with just the right number of bedrooms and bathrooms, and the perfect space for outdoor dinner parties? That kind of house can be tough to find in any market.

Maybe you’ve found a fixer-upper on a perfect plot of land that would need a total gut renovation. Or maybe you’ve got a perfect piece of land in the ideal location, and all you need now is the house. So how do you get started? And how do you afford it?

When you buy a house, you can finance it with a mortgage. But when you build a house, getting financing is trickier. That’s because building projects require money in stages, and borrowing large sums of money can be difficult when there’s no collateral to guarantee the loan.

A construction loan is one of the ways that home builders finance their projects. These are loans that can help you finance a construction project in stages. However, these loans can be pretty complicated. In fact, they often require more upfront legwork than a mortgage to convince lenders that the project is viable. Let’s take a look at how construction loans work and what the rates, terms, and requirements are, so you can figure out if it’s the right option for you.

How do construction loans work?

Construction loans are loans that finance the building of a new home or substantial renovations to a current home. These loans are typically short-term, variable interest rate loans. They are 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.

Popular Home Construction Loan Options:

“Construction-to-Permanent” Loans

These are sometimes referred to as “single-close” loans. These are construction loans that convert into a mortgage once the home is finished.

“Construction-Only” Loans

This type of construction loan must be paid off or refinanced when the building is complete. These loans can require borrowers to qualify and pay closing costs multiple times during the home-building process.

Renovation Construction Loans

These are specifically designed to cover the cost of substantial renovations (or the cost of improving a fixer-upper). These 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. Before funds are disbursed, your lender will frequently send a representative to monitor the progress of the project and make sure everything’s on schedule.

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 help facilitate the process. Because your house 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, complete 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 – sometimes up to 35%. 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 to your own profile, they’ll want a detailed plan, budget, and schedule for the construction. Some lenders will also need to approve your builder. Since 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 construction loan interest rates and terms?

Typically, construction loan rates rise and fall with the prime lending rate. However, they tend to come with much higher interest rates than mortgages. Since these loans are such a small part of the lending market, lenders typically don’t even advertise construction loans all that much, which is why shopping around can be time-consuming.

The terms on construction loans also vary quite a bit depending on the type of construction loan you are seeking. Typically, these loans are short-term, only covering the cost of building while the building is actually in progress. During the construction, you are usually only required to make monthly interest payments. When your home is finished, the loans either come due or are rolled into a permanent mortgage, depending on the type of loan.

Are there any alternatives to construction loans?

A lot of time and effort goes into securing a construction loan. It can be difficult to find lenders that offer competitive rates, and even more difficult to qualify for them—particularly if you don’t have a flawless credit history. Plus, they tend to be complicated because it is often the builder who has to carry the loan. Due to the risk construction loans pose to lenders, they often come with high interest rates as well.

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. Two of those options are a personal loan and a cash-out refinance.

Personal Loans for Major Renovations

Using a personal loan for your home can be a good source of financing for a renovation project or a tool to supplement other construction financing. The major benefit to a personal loan is convenience; It can be much faster and easier to secure, and there are fewer hoops to jump through in order to get approved.

They also are likely to cost less in interest than a construction loan, depending on your financial profile. And you can frequently choose a loan with a fixed interest rate, which means your rate won’t change over time. 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 drawback? You won’t be able to roll your personal loan into a mortgage once your renovation or building project is finished. And since 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 Refinancing for Construction Costs

A cash-out refinance is also a good financing tool, particularly if you have a lot of equity stored in your current home, and your home has appreciated in value. 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 comes with construction loans.