DEFINITION of Construction Mortgage

A construction mortgage is a loan borrowed to finance the construction of a home and typically only interest is paid during the construction period. Once the construction is over, the loan amount becomes due and it becomes a normal mortgage. The money is advanced incrementally during construction, as construction progresses.

BREAKING DOWN Construction Mortgage

Financing to build a new home typically comes in the form of a construction-to-permanent 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.

How Construction Mortgages Are Used

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 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 rate once construction begins.

If the borrower does not take out a construction-to-permanent loan, they could make use of a standalone construction loan, which typically has one year maximum term. Such a construction mortgage might call for a smaller down payment. If interest rates fluctuate during construction, the borrower may have to pay larger installments. 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.

The borrower made need to apply for a separate mortgage to pay for the construction mortgage debt, which would be due after completion. It is possible for the borrower to sell their existing home and live in a rental or other 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 construction of the new home, meaning the construction mortgage would be the only outstanding debt.

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. Within the contract, details must be included such as the start and expected completion date, as well as the overall contract amount, which includes construction and if applicable cost of land.