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Construction Loans: Everything You Need To Know

Carey Chesney5-minute read

May 04, 2022

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Finding the perfect house can be a fun yet challenging endeavor. With so many styles to choose from – colonial, ranch, mid-century modern, townhouse and tudor, just to name a few – sometimes people don’t know where to even start.

And if you’ve decided on your favorite style, a slew of other must-have factors come into play, such as the size of the home and location. With all these considerations going through your head and a limited number of properties on the market, finding your dream home in your ideal location within your budget can seem impossible.

Oftentimes, buyers find that some houses meet most of their needs, some meet a few and some meet none, but rarely does one meet them all. This creates the need to compromise and move some of your “must-haves” to “nice-to-haves,” but not deal-breakers.

Don’t feel like giving an inch on your wants and needs? Fear not, because if your perfect home isn’t available (or doesn’t even exist), you can build a new one. This allows you to create the picture-perfect home without worrying about the factors of buying a home that’s already been lived in. However, to finance this build, you’ll need to know about construction loans.

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What Is A Construction Loan?

A construction loan is a short-term loan that covers only the costs of custom home building. This is different from a mortgage, and it’s considered specialty financing. Once the home is built, the prospective occupant must apply for a mortgage to pay for the completed home.

However, there are several other loans available when it comes to home building, from ground-up building to a complete remodel of the entire house. There’s likely a loan out there that’s right for you, whether you’re starting from scratch with a land loan or completely renovating a home.

Construction-Only Loan

This type of loan is short-term and is usually issued for a year. It’s meant to cover only the actual construction period. Like many lenders, Rocket Mortgage doesn’t offer this type of loan. Why? With so many variables like the builder’s cooperation, getting approvals from local municipalities and more, these are considered higher-risk loans.

This means they’re harder to qualify for, and the interest rate will likely be higher than a traditional loan. In addition, if you decide to go this route, you’ll have to pay a second set of loan fees when you apply for a traditional mortgage.

Construction-To-Permanent Loan

Construction-to-permanent loans are a financing option that prospective custom home builders can apply for. Like construction-only, construction-to-permanent financing are one-time loans that fund construction and then convert into a permanent mortgage. During the construction phase, borrowers make interest-only payments.

These types of loans can be much more expensive than traditional mortgages, so if you decide to go in this direction, shop around, compare rates and find the best deal before you pull the trigger.

Renovation Loan

Renovation loans, also known as FHA 203(k) loans, can be used for home renovation and are insured by the Federal Housing Administration (FHA). This allows borrowers to both purchase and renovate their new home while still making one monthly payment to cover both costs. Conventional loan borrowers may qualify for these loans through Fannie Mae (HomeStyle Renovation) and Freddie Mac (CHOICE Renovation).

Rocket Mortgage doesn’t offer this type of loan. However, Rocket Mortgage does offer a cash-out refinance, which can be a different path to getting home renovations done. With a cash-out refinance, you take a portion of your equity and add what you’ve taken out onto your new mortgage principal.

Other options include a home equity loan or a home equity line of credit (HELOC). No matter what you want to change about your home, there are plenty of options to get the financing you need to start swinging that sledgehammer.

Owner-Builder Loan

Usually when you build a home, there’s a general contractor who essentially acts as head of the whole operation. They make sure the framing people, the tile people, the wood floor people, the painters and so on all work in coordination to get your home completed (ideally on time and on budget).

However, some prospective home builders wish to act as their own general contractor, and some banks offer owner-builder loans just for this purpose. These types of loans generally require the borrower to demonstrate through experience, education and licensing that they have the needed expertise to oversee the home’s construction.

End Loan

An end loan is a traditional mortgage loan that a home buyer or home builder (if you’re building your own home) can apply for after the new home is constructed. Unlike some of the other construction loans previously discussed, these are offered by Rocket Mortgage.

You can get an end loan if construction is complete on the home. One good aspect of an end loan is that the mortgage application for a newly constructed home is the same as it is for any other home. Less complicated is always appreciated when it comes to financing applications.

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Construction Loan FAQs

Hopefully you have a nice base of knowledge about home construction loans after reading this far, but there are likely a few queries still on your mind. Here are some frequently asked questions when it comes to construction loans.

Are there higher qualification requirements for construction loans?

Yes, construction loans often come with higher qualifying standards in terms of credit score requirements and down payment amounts. Usually a minimum 20% down payment is required, and a 25% down payment requirement is not uncommon. In addition, most construction loans require a minimum credit rating of 620.

Can I use any excess funds for home furnishings?

Borrowers never actually touch the funds made available through construction loans because they’re paid directly to the builder.

The contractor only receives payment for the work performed, and the borrower only pays interest on what’s paid out. You do save money if construction costs come in below the original amount of the loan, but you’ll have to find some other source of funds for that flat screen.

Do construction loans cover the design phase of home construction?

No. Prospective custom home builders have to self-finance the design phase of the home building contract. In addition, before you can take out a construction loan, you’ll need to produce a builder’s contract, construction timetable, designs and a realistic budget. All this needs to be done even before beginning the loan application process.

The Bottom Line: Construction Loans Can Make Your Dream A Reality

If it doesn’t look like your ideal home is available while you peruse the listings in your preferred market, the dream doesn’t have to end. Envisioning the perfect mix of location, style and usability in a home is one of the most fun parts of the home buying process and it doesn’t have to be just a vision. You can design, build and furnish the exact home you want with a variety of financial support paths to help get you there.

Whether it’s a construction loan, a renovation loan, a HELOC or any other number of options, finding the right way to borrow money for your next home doesn’t have to be too hard. Research all the options, figure out the best type of loan for your specific needs and shop around for the best price.

Still not sure where to go next? A great way to continue learning more about how to finance your real estate dreams is by visiting the Rocket Mortgage Learning Center.

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Carey Chesney

Carey Chesney brings a wealth of residential and commercial real estate experience to readers as a Realtor® and as a former Marketing Executive in the fields of Health Care, Finance and Wellness. Carey received his Bachelor's in English at University of Wisconsin-Madison he received his Masters in Integrated Marketing & Communications at Eastern Michigan University.