Understanding Construction Loans vs Mortgages: Which Do You Need and How Do They Compare?

Construction loan vs. mortgage
Construction loan vs. mortgage

The year 2021 was actually great for selling homes, and not so great for buying homes since prices rose because of economic instability. 

Then again, there were also lower than average mortgage rates for first-time buyers. The year 2022, warts and all, is still expected to “balance out” in ways that 2021 never did. 

That brings us to the next great financial debate – construction loan vs. mortgage. Mortgage rates are still low and the market looks promising. But the option of a construction loan is also exciting! Let’s consider the pros and cons of a construction loan. 

Understanding Construction Loans

Construction loans are what they sound like, at least in the sense that the financial company covers the cost of building a new house or renovating it. But you don’t get the money – the contractor does. 

The lender will also want installment payments according to the milestones of the contract. When the contractor finishes, the loan can be paid off or converted into a permanent mortgage. The loan is also thorough, covering everything from land to permits, plans, labor, materials, and even closing costs. Even if the project costs more than is initially stated, the loan covers that. 

Types of Construction Loans

There are three main types: 

Single Close: This type of loan converts to a mortgage when the building is finished. Since interest rates are locked in at the outset, homeowners will have predictable interest rates. 

Two Close: These loans require the homeowner to pay off the loan upon completion of the project. Given the huge amount of money promised, qualifications are tight. Eligibility is based on cash on hand or a working relationship with a trusted permanent lender. 

Renovation: Renovation construction loans put the cost of renovations into the mortgage, rather than financing it. The total loan price is then based on the home value after renovation. If you want to buy a fixer-upper house but can’t afford the construction, this scenario is preferred.

Differences Between Construction Loans and Traditional Mortgages

The very fact that construction loans are short-term should tell you that they automatically have higher down payments, higher interest rates, and a somewhat complex approval process. 

The lender carries the risk on a construction loan, even more so than a mortgage. That’s why the lender is going to take a very hands-on approach to the project. 

Will You Qualify for a Construction Loan?
Will You Qualify for a Construction Loan?

Will You Qualify for a Construction Loan?

To qualify for a construction loan, like any other mortgage, the lender will look at your credit score, debt-to-income ratio, and a stable cash flow. In addition, because of the nature of the work, the lender will also want to see your detailed plan.

Who Chooses the Contactor for a Construction Loan?

In most cases, the plan will come from the construction company you want to hire. However, you can’t just hire anybody. The lender must be licensed and have demonstrable expertise in completing similar projects. If you want to choose a contractor you know, ask for recommendations from their past clients. 

If you don’t know where to start you can get contacts from the National Association of Home Builders on their directory page.

The lender will also send out representatives to oversee the construction process and possibly veto some of your contractor choices based on various risk factors. The company will also likely require a payment bond on the project.

Get It Together!

You will be required to get all related documents together for the lender’s review. This includes:

  • Pricing
  • Project plans with timetables
  • References for the contractor
  • Proof of credentials
  • Financial records for the contractor’s business (if requested)
  • Appraisal of the finished house

Getting all of this paperwork together also requires you to talk things over with the contractor to get a clear view of the project, including any other factors that could affect the timeline. 

If you need a comparison, here is a construction project plan. But the lender may require one even more detailed according to their own terms. 

Different Rates for Construction Loans vs Mortgages

Interests rates can be tricky since lenders charge interest based on the construction loan money that is actually used during construction. If not all of it is used, you are not charged the entire interest amount. 

That said, interest rates for construction loans are still higher than home loan rates, as we see from a typical example from SoFi.com. Construction loans last about a year or slightly more, just long enough for the construction project to end. This means interest rates are variable unless you get a single close type of loan.

On average, construction loan rates are about 1-2% more than traditional mortgage rates.

Pros of a Construction Loan

  • You get to literally build your dream home!
  • Short term contracts – most projects take about a year
  • Maybe the option of converting the loan to a regular mortgage
  • Installment payments to make sure the work is done

Cons of a Construction Loan

  • Lots of dudes outside your house checking up on things
  • A mess of paperwork
  • Big down payment and at least 20% equity
  • Harder to qualify for
  • Big monthly payments because of a shorter contract
  • Higher interest rates 
Dream Home or Dream Scenario?
Dream Home or Dream Scenario?

Dream Home or Dream Scenario?

If you can afford a construction loan, it’s a tempting deal for sure. You get upfront funding to purchase land and you can even turn any remaining costs of repairs into a mortgage after the home’s completion. 

If you have a grand vision of a dream home then by all means, build it! You will never find the perfect house if you have a distinct image in your mind. 

But if the price is your main concern, a traditional home loan is the simple solution. There’s less stress involved in buying a home that suits your needs, versus trying to create your ideal home in an imperfect environment. You also have to consider the state you’re in, the region and its landscaping, and other external factors. 

TheOwnerBuilderNetwork.co can help you with house hunting for the perfect established home or get you that fixer-upper you can’t stop thinking about. Why not contact a local supplier from our directory?

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