Construction loans: Everything you need to know

Financing a custom home build often starts with a construction loan, a short-term option designed to cover the cost of building a home from the ground up. While Rocket Mortgage doesn’t offer construction loans, Rocket Mortgage provides guidance on how construction loans work, what borrowers typically need to qualify, and how construction financing may later convert into a traditional Rocket Mortgage loan once the home is complete.

In this guide, we’ll explain what construction loans are, how they compare to traditional mortgages, the types of home construction loans available – including land and construction loans and owner builder construction loans – and the steps involved in applying.

What is a construction loan?

A construction loan is a short-term loan used to pay for the cost of building a home, rather than purchasing an existing one. These construction loans are considered specialty financing because they’re designed specifically for the home-building process and typically cover only construction-related expenses.

Once the home is complete, borrowers usually apply for a traditional mortgage to pay off the construction loan and finance the finished home. While Rocket Mortgage doesn’t offer construction loans, we can help when it’s time to transition to a permanent mortgage.

Construction loans vs. traditional mortgages

There are several key differences between a construction loan and a traditional mortgage. The table below highlights the most important distinctions at a glance.

Construction loans are designed to be temporary. They’re usually short-term loans, often lasting no more than a year, and borrowers typically make interest-only payments while the home is being built. Because the home doesn’t yet exist as collateral and there’s more uncertainty involved, construction loans generally come with higher interest rates.

Traditional mortgages, by contrast, are long-term loans with repayment periods that usually range from 15 – 30 years. With a mortgage, the borrower receives the loan funds in one lump sum at closing, and payments begin right away. These payments include both principal and interest, and interest rates are typically lower because the lender is financing a completed home, which carries less risk.

How do construction loans work?

You can use a construction loan to cover the total cost of building a home, including the land, labor, materials, and permits. The approval process for a construction loan is similar to that of a typical mortgage in that you’ll need to apply and submit documentation to your lender.

Once approved, you’ll be able to start accessing the funds in conjunction with each phase of construction. An appraiser or inspector will check in on the build throughout the construction process so that the borrower can continue to have access to funds.

After the home’s construction is complete, you’ll be issued a certificate of occupancy. Then, your construction loan will likely be converted to a traditional mortgage, and you’ll begin to make payments on the principal and interest.

Types of house-building loans

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.

While Rocket Mortgage will go over several types of financing for building your home, we offer end loans, which are the permanent financing after the home is built.

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. Why don’t we offer this type of loan? 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. If you’re an active-duty service member or veteran, you may even qualify for a VA construction loan from the Department of Veterans Affairs (VA).

Owner-builder construction 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 within your 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 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.

Renovation loan

Renovation loans are sometimes used during the construction or remodeling phase, but they’re different from construction loans and are generally designed for updating or repairing existing homes rather than building from scratch.

Common renovation financing options include:

• FHA 203(k) loans, insured by the Federal Housing Administration
• Conventional renovation loans such as HomeStyle Renovation (Fannie Mae) and CHOICE Renovation (Freddie Mac)
• A cash-out refinance to fund getting home renovations done
• A home equity loan or home equity line of credit (HELOC)

Rocket Mortgage doesn’t offer renovation loans, but Rocket Mortgage does offer cash-out refinance options that may help homeowners fund updates. If you’re considering renovations, explore these options further to determine the best fit for your project and timeline.

Construction loan rates

Construction loans usually have variable interest rates, meaning the rate will go up and down with the prime rate  (or whatever other index they’re tied to) over the life of the loan. The specific introductory interest rate you’re offered for a construction loan depends on factors like your credit score and financial history.

As mentioned, because they aren’t secured by a completed house, construction loans tend to have higher interest rates.

Construction loan requirements

Like with a regular mortgage, construction loan lenders have requirements that borrowers will need to meet in order to qualify for the loan.

• Credit score: Minimum credit score of 620 or higher is generally required.
• Debt-to-income (DTI) ratio: DTI ratio compares your recurring monthly debts to your gross monthly income.
• Down payment: You’ll likely need a down payment of 20% when taking out a construction loan.
• Choice of builder: The lender will need to approve the builder of your new home and verify their licensing and insurance.
• Construction plan: The lender will also need to approve your construction plan. A signed contract, blueprints, a line-item budget and a payment schedule are all examples of documentation your lender may want to see.

How to get a construction loan

Applying for a construction loan involves more preparation than a traditional mortgage, but breaking the process into clear steps can make it feel far more manageable. From choosing the right builder to securing insurance, each step plays a role in helping your project stay on track.

1. Choose a builder

Before you begin to search for a lender, you’ll want to choose an experienced builder for your new home. Be sure to thoroughly vet any contractor you’re considering working with. Read online reviews, ask about their credentials and look at examples of previous builds they’ve done to get an idea of if they’re the right choice to meet your needs.

2. Gather your paperwork and choose a lender

Just like with a traditional mortgage, you’ll want to shop around for a lender that will give you the most favorable terms for your construction loan. As you’re comparing lenders, make sure you have all your paperwork ready to go, including the contract with your lender and detailed plans for your home’s budget and construction.

3. Start the approval process

Getting your preapproval for a construction loan is an important step in ensuring that you’ll be able to afford the amount needed to build your dream home. You’ll need to provide the same types of financial documents as you’d need when applying for a traditional mortgage, including your tax returns, W-2s, and bank statements.

4. Purchase homeowners insurance

Even though you won’t be living in your home while it’s being built, your lender will probably require you to have homeowners insurance with builder’s risk coverage as a condition of your loan approval.

Construction loan FAQs

Here are some frequently asked questions when it comes to construction loans.

What if my home construction takes longer than planned?

Any delays that exceed the loan’s terms can lead to penalties and/or higher interest rates. If these delays are related to unforeseen costs, it may be difficult to budget for these expenses, as the loan amount was set in advance. Some lenders may allow extensions, but additional fees or rate adjustments may apply.

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

A construction loan is short-term financing that covers the cost of building a home from the ground up and typically converts to a traditional mortgage once construction is complete. To qualify, borrowers usually need strong credit, a stable financial profile, an approved builder, and detailed construction plans. The process includes choosing a builder, gathering documentation, applying with a construction loan lender, and securing insurance during the build.

If you’re ready for permanent financing after construction or want to explore your next steps, we can help. Start an application with Rocket Mortgage online to see what options may be available for you.

This article is for informational purposes only and is not intended to provide financial, investment, or tax advice. You should consult a qualified financial or tax professional before making decisions regarding your retirement funds or mortgage.

Refinancing may increase finance charges over the life of the loan.

Rocet Mortgage is a trademark of Rocket Mortgage, LLC or its affiliates.