What is Construction Mortgage?

A construction mortgage is a type of mortgage used to finance the construction of a home, and typically only requires interest be paid during the construction period. Once the building phase is over, the loan amount becomes due and it becomes a standard mortgage. The money loaned is typically advanced incrementally during the building phase as construction progresses.

Key Takeaways

  • A construction mortgage is a loan used to pay for building a new home, after which time the loan may convert into a standard mortgage.
  • During construction, most loans of these type are interest-only and will disburse money incrementally to the borrower as building progresses.
  • The two most popular types of construction mortgage are standalone construction and construction-to-permanent mortgages.
  • The former are often only offered as a one-year term, while the latter will convert to a standard mortgage when the home is built.

How a Construction Mortgage Works

Often financing to build a new home comes in the form of a construction-to-permanent construction loan. This financing option has two parts: a loan to cover the costs of construction and a mortgage on the finished home. The advantage of such plans is that you have to apply only once, and you will have only one loan closing.

Construction mortgages may be sought as a way to better ensure that most—if not all—construction costs are covered on time, usually preventing delays in the completion of the home. It is possible that unforeseen expenses may arise, increasing the overall cost of construction.

Lenders may offer different options to make construction mortgages more attractive to borrowers. This could include interest-only payments during the construction phase, and for construction-to-permanent loans, they might also offer locked-in interest rates once construction begins.

Construction-to-Permanent vs. Standalone Construction Loans

If the borrower does not take out a construction-to-permanent loan, they could make use of a standalone construction loan, which typically has a one-year maximum term. Such a construction mortgage might call for a smaller down payment. The interest rate cannot be locked in on a standalone construction mortgage. The base interest rates might also be higher than a construction-to-permanent loan.

If interest rates fluctuate during construction, the borrower may have to pay larger installments.

The borrower made need to apply for a separate mortgage to pay for the construction mortgage debt, which would be due after completion. The borrower can sell their existing home and live in a rental or another type of housing during construction of the new residence. That would allow them to use equity from the sale of their previous home to cover any costs after the creation of the new house, meaning the construction mortgage would be the only outstanding debt.

Special Considerations

Applying for a construction loan includes a review of the borrower’s debts, assets, and income. The borrower must also have a signed purchase or construction contract with the builder or construction company to qualify for a construction loan. Within the agreement, details must be included, such as the start and expected completion date, as well as the overall contract amount, which provides for construction and if the applicable cost of land.