Construction Loans 101: How to Finance Building a New

Construction Loans 101: How to Finance Building a New Home

Building a home from the ground up gives you exactly what you want. But financing new construction is fundamentally different from buying an existing home. The loan structure, the timeline, the risks, and the requirements are all more complex. Here is how construction loans work and what you need to know before you break ground.

Why You Cannot Use a Regular Mortgage

A standard mortgage is secured by a finished home with a known value. When you are building, there is no finished home yet. The lender is funding a project that does not exist, being built by contractors who might run into delays, on a timeline that could shift. That additional risk changes everything about how the loan works.

Types of Construction Loans

Construction-to-permanent (one-time close). This is the most popular option for owner-builders. You close once. The loan starts as a construction loan during the building phase, then automatically converts to a permanent mortgage when construction is complete. You pay closing costs once, lock your permanent rate upfront (or at conversion, depending on the lender), and avoid the risk of not qualifying for a mortgage after the build.

Construction-only loan. This covers only the building phase. When construction is complete, you need to obtain a separate permanent mortgage to pay off the construction loan. That means two closings, two sets of closing costs, and the risk that your financial situation or rates could change between the two loans. This option sometimes makes sense if you want to shop for the best permanent mortgage rate after the home is built.

Owner-builder loan. If you are acting as your own general contractor, some lenders offer owner-builder construction loans. These are harder to qualify for because lenders want assurance the project will be completed properly. You typically need to demonstrate construction experience or trade credentials.

Renovation construction loans. Programs like the FHA 203(k) and Fannie Mae HomeStyle Renovation loan combine purchase and renovation financing. These are for major renovations to existing structures, not ground-up builds, but they share some characteristics with construction loans.

How the Draw Process Works

Unlike a regular mortgage where you receive the full loan amount at closing, construction loan funds are disbursed in stages called draws. As the builder completes each phase of construction, they request a draw. The lender sends an inspector to verify the work is complete, then releases the funds.

A typical draw schedule might look like this:

• Draw 1: Foundation and slab — 15%
• Draw 2: Framing — 20%
• Draw 3: Mechanical rough-in (plumbing, electrical, HVAC) — 15%
• Draw 4: Insulation, drywall, and exterior — 20%
• Draw 5: Interior finishes (cabinets, flooring, fixtures) — 20%
• Draw 6: Final completion and landscaping — 10%

During construction, you typically make interest-only payments on the amount that has been disbursed. As more draws are released, your monthly payment increases. Full principal and interest payments begin when the loan converts to a permanent mortgage.

Qualification Requirements

Construction loans have stricter requirements than standard mortgages:

• Credit score: 680 to 720 minimum (higher than conventional purchase loans)
• Down payment: 20% to 25% of the total project cost is typical. Some lenders allow 10% to 15% with strong compensating factors.
• Debt-to-income ratio: Usually capped at 43% to 45%
• Cash reserves: 6 to 12 months of payments in reserve
• Licensed builder: Most lenders require you to use a licensed, insured general contractor with a track record of completed projects
• Detailed plans and budget: Complete architectural plans, specifications, and a line-item construction budget are required before approval

Costs You Should Expect

Construction loans are more expensive than standard mortgages in several ways:

• Higher interest rates: Expect rates 1% to 2% higher than permanent mortgage rates during the construction phase
• Inspection fees: The lender charges for each draw inspection, typically $100 to $200 per inspection
• Longer timeline: Construction typically takes 8 to 14 months. Interest-only payments during this period add up.
• Contingency reserve: Lenders usually require a 10% to 15% contingency built into the budget for cost overruns. This is smart — construction projects almost always cost more than the initial estimate.

Choosing Your Builder

Your lender will scrutinize your builder almost as carefully as they scrutinize you. They will want:

• A valid general contractor's license
• Proof of liability and workers' compensation insurance
• References from recent completed projects
• Financial stability (some lenders check the builder's credit)
• A detailed construction contract with a fixed price or guaranteed maximum

Do your own due diligence beyond what the lender requires. Visit the builder's completed projects. Talk to previous clients. Check for complaints with your state licensing board and the Better Business Bureau.

Protecting Yourself During Construction

Get a fixed-price or guaranteed maximum price contract. Cost-plus contracts (where you pay actual costs plus a percentage) leave you exposed to unlimited overruns.

Include a completion timeline with penalties. Your contract should specify a completion date and consequences for delays that are within the builder's control.

Do not make the final payment until everything is done. Hold back 5% to 10% of the contract price until all punch-list items are resolved and you have received a certificate of occupancy.

Get builder's risk insurance. This covers damage to the structure during construction from fire, storms, theft, and vandalism. Your lender will likely require it.

Is Building Right for You?

Building a home gives you complete customization and a brand-new structure with modern efficiency. But it requires more capital, more patience, and a higher tolerance for uncertainty than buying existing construction. If you have the financial cushion and the temperament for a 12-month project, building can be deeply rewarding. If you need to move quickly or are stretching your budget, buying an existing home is likely the safer path.

Considering building? SOMA can help you understand the financing options and compare the costs of building versus buying. Start at heysoma.ai.