What is 'Construction Loan'
A construction loan (also known as a “self-build loan") is a short-term loan used to finance the building of a home or another real estate project. The builder or home buyer takes out a construction loan to cover the costs of the project before obtaining long-term funding. Because they are considered fairly risky, construction loans usually have higher interest rates than traditional mortgage loans.
BREAKING DOWN 'Construction Loan'
Construction loans are usually taken out by builders or home buyers who are custom-building their own home (see "Getting a Mortgage When Building Your Own Home"). After construction on the house is complete, the borrower can either refinance the construction loan into a permanent mortgage or get a new loan to pay off the construction loan (sometimes called the “end loan”). The borrower might only be required to make interest payments on a construction loan while the project is still underway. Some construction loans may require the balance to be paid off entirely by the time the project is complete.
If a construction loan is taken out by a borrower who wants a home built, the lender might pay the funds directly to the contractor rather than the borrower. The payments may come in installments as the project completes new stages of development. Construction loans might be taken out to finance rehabilitation and restoration projects as well as to build new homes.
Limits and Requirements of Construction Loans
Most lenders require a 20% minimum down payment on a construction loan and some require as much as 25%. Borrowers may face difficulty securing a construction loan especially if they have limited credit history. The lack of collateral because the home has yet to be built can also pose a challenge in seeking approval from a lender. To gain approval for a construction loan, the borrower will need to provide the lender with a comprehensive list of construction details (also known as a “blue book”). The borrower will also have to prove they have a qualified builder involved in the project.
Construction loans are usually offered by local credit unions or regional banks. Local banks tend to be familiar with the housing market in their area and are generally more comfortable making home construction loans to borrowers in their community.
If a borrower intends to act as his own general contractor or build the home with his own resources, he will likely take out a variant of this type of financing called an owner-builder construction loan.