The Ins and Outs of Getting a Home Construction Loan

February 17, 2012 by  Filed under: Loans 

A home construction loan can be used for new home construction or for remodeling an existing home. They can be obtained through banks, credit unions and mortgage companies, but not every lender offers them.

According to, rates are higher for a construction loan compared to a conventional mortgage because the asset- the new home – is not yet built and is therefore a higher risk.

The money is disbursed based on a construction schedule agreed upon by the homeowner, contractor and lender. These disbursements, called draws, are given out when each phase is completed. If the homeowner takes out the loan, he or she is responsible for paying the contractors. Lenders will usually verify that the work has been completed before releasing the money.

There are two types of home construction loans: construction only and all-in-one. Both are short-term, ranging from six months to a year, and are usually limited to 90 percent of the construction costs. The borrower puts up the other 10 percent in the form of a cash down payment, or uses the land or equity built up in the current home as collateral.

The construction-only loan, sometimes called a construction line of credit, often has a variable interest rate. After construction is complete, the entire amount becomes due, and the loan is converted to a conventional mortgage or replaced with another loan. This second loan is occasionally referred to as a take-out loan.

The main advantage of a construction-only loan is flexibility; you can increase the amount borrowed during construction, and you have time to shop around and decide which lender you want to go with long term. Disadvantages include a higher interest rate, two sets of closing costs and a potential rise in interest rates between the two loans.

The all-in-one loan, also called a combination or a rollover loan, works the same as a construction loan but when construction is finished, it automatically rolls over into a mortgage. Advantages include one set of closing costs, less paperwork and one interest rate. If interest rates go down, however, you are locked into the initial rate. Also, the loan amount cannot be increased; if you don’t take out enough to cover total costs, you may end up taking out another loan.

Lenders consider two key criteria when evaluating a request for a construction loan: your ability to repay the loan and your credit report.

When determining your ability to repay, lenders look at the housing ratio, calculated by dividing monthly housing expenses by gross monthly income, and the debt-to-income ratio, calculated by dividing fixed monthly expenses by gross monthly income. According to, the housing ratio should not exceed 30%; the debt-to-income ratio should not exceed 36%.

The credit report is important because it lists payment delinquencies over the past three years. Any delinquencies should be corrected before applying for a loan. The number varies among lenders but typically they look for a credit score of at least 620 to 700.

In addition to your credit report, lenders will want to see the following documents:

  • Current pay stubs along with W2s and tax returns for the previous three years.
  • Checking and savings statements, 401(k) and investment portfolios.
  • Building plans and materials list.
  • Detailed construction budget, including permit fees and material and labor costs.
  • Land deeds or sales contracts for the construction site

Alex Levin is a writer for Granite Transformations and JW Surety Bonds. When he’s not helping contractors understand the surety bonding process, he writes about construction-related news and events.

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