How to Obtain a Loan to Build a House (A Step-by-Step Guide)

Construction loans are short-term finances issued by lenders to cover the cost of building a house. The loan is usually paid to the contractor – not the debtor – in instalments as specific construction milestones are achieved.

The rates for construction loans are usually higher than those of ordinally mortgages as most lenders consider them to be relatively risky.

However, despite the higher construction loan rate, many homebuilders often procure these loans to cover initial project costs before obtaining long-term credit.

In most cases, home construction loans are converted to permanent mortgages although some lenders demand full repayment at the end of the project.

Taking a loan to build a house

Here are the three main types of construction loans and how they work.

Construction-only loans

Also known as two-close construction loans, these debts must be paid in full upon the completion of a house-building project. 

Construction-only loans require the borrower to qualify, obtain approval, and pay closing costs several times. They are ideal for investors with a large cash reserve or those who want to shop for a long-term sponsor during the construction phase.

Construction-to-permanent loans

Also known as single-close loans, these types of loans are usually converted into permanent mortgages upon the completion of a house.

These loans are suitable for people with straightforward building plans as well as individuals looking for predictable interest rates.

Owner-builder construction loan

These are construction-to-permanent or construction-only loans where the borrower also acts in the capacity of the home builder.

Due to the complexity of a house construction project, and the legal requirement to comply with a country’s building codes, owner-builder construction loan is typically only issued to borrowers who are licensed builders by trade.

Rates for construction loans

The rates for construction loans vary depending on the level of risk as determined by the lender and the ability of a borrower to make the repayment.

That being said, the construction loan rate is usually in the 5% to 10% range – and at least 5% above the traditional permanent mortgage rates.

What do construction loans cover?

While every project has its unique funding requirements, home construction loans usually pay for land purchases as well as building plans, permits, and fees.

These loans also cover materials and labor costs; closing costs; contingency reserves (in case of cost overruns); and interest rates reserved for those who do not want to make interest payments during the construction process.

How do construction loans work?

A new construction loan is the most common type of financing for home projects. It usually covers the cost of buying land as well as house-building costs.

The loan is converted into a permanent debt once the house is completed.

It is offered at a down payment of 10% to 20% – with some lenders asking for a lower down payment for those willing to pay a higher interest rate.

To qualify for this financing option, you need an excellent credit score, a low debt-to-income ratio, as well as detailed architectural plans for your project.

Since construction loans are short-term debts that are tied to the completion of a project, you must provide a lender with a timeline, detailed plans and a budget.

Unlike personal loans that make a lump-sum payment to the borrower once a funding deal is approved, construction loans are paid (to the contractor – not the borrower) in instalments as construction milestones are achieved.

Steps to get a loan to build a house

Obtaining a construction loan is a little bit more complicated compared to getting approval for a traditional mortgage.

Here’s how to obtain a construction loan:

1.) Find a builder: Lenders will only consider your application if your project is being undertaken by a licensed builder with adequate homebuilding experience.

2.) Compile your documents: Lenders will typically ask for a signed agreement with your builders. The contract should state the budget and timelines for the project.

3.) Obtain preapproval: This will help you to get an accurate figure of the amount a lender is ready to issue for the project. A pre-approval can help you to avoid acquiring blueprints for a house that you cannot afford.

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