How is a Home Construction Loan Different from Buying an Existing Home?

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Building your own home can be an exciting time! There are numerous decisions to make and the ability to make your dream home come true. With that excitement, however, comes the need to have a different type of financing. Unlike purchasing an existing home, you will have a construction loan, which in reality is two different loans that work into one loan in the end. The eligibility process is similar for both loans, meaning that you will have to prove your financial worth in order to be able to get a construction loan, but the similarities end there.


The first part of a construction loan is the part that enables you to pay for the costs of the home. These costs include things like:

  • Architectural plans
  • Materials
  • Contractors
  • Cost of the land
  • Permit costs
  • Labor for sub-contractors
  • Appliances
  • Special upgrades

This is the loan you will close on first when you go to the loan closing. This loan closing will also differ than what you are used to with an existing home. You will sit down and sign a large amount of paperwork – that much is the same. You will still have a note, deed, and various other documents to sign. But, the disbursements of the loan will be different at this point. When you purchase an existing home, the entire amount of the purchase price gets disbursed directly to the seller at the closing. The seller walks away with a check and you walk away with a coupon book that requires you to make monthly payments to pay that loan back. In a construction loan, only a small portion of the loan amount is disbursed right away. This amount is predetermined based on the budget that was set for the project as well as the disbursement schedule that was set up in the contract that was approved by the builder, lender, and yourself. The initial disbursement is typically just to get the builder started. The costs included in the initial draw usually include the cost of materials and any down payments that the contractors require. If the land was not previously owned by you, that money will also be disbursed to the seller of the land. The remaining funds are placed in an escrow account and are disbursed according to the draw schedule. Every lender will disburse funds differently – some allow monthly disbursements during the building process, while others strictly disburse at the beginning, middle, and end following the final inspection.


Another major difference between a construction loan and a loan for an existing home is the amount of the loan you can receive. Even if you have stellar credit, you should not expect to receive a loan that exceeds 80% of the proposed future value of the home. This is strictly for the safety of the bank. Construction loans are considered rather risky. If the bank were to lend you 97% of the future value of the home, as they offer for qualified borrowers with conventional financing on existing homes, there is nothing really holding you to your promise to pay the loan, which leaves the bank at risk for having to find a buyer for the home that you designed, which is not an easy task. Most banks will require at least a 20% down payment from you in order to ensure that you have a reason to stay in the home.


Most banks will require much higher credit scores for construction loans than they would for loans for existing homes. This again, is because of the risk level involved. Every bank has their own requirements as these loans typically stay “on the books” of the bank, but typically, most banks will not go much lower than a 700 credit score. If the bank were to consider a lower score, it would only be because other compensating factors really made it worth the risk for them to take. These compensating factors could be things like:

  • Already owning the land that the house is to be built on
  • Having a large amount of liquid assets and/or large down payment
  • Having a very low debt-to-income ratio

If any of these situations are in place, the bank might be more willing to overlook a blemish or two on a credit report or a lower than usual credit score for a construction loan.


The debt-to-income ratio requirement for a construction loan is rather similar to that of a loan for an existing home. Lenders typically want all borrowers to be at 28% on the front end of the ratio and 36% on the back end. This means that only 28% of the borrower’s gross monthly income is required to make the monthly mortgage payment and 36% is needed to meet all of the monthly requirements. There is some leeway on these debt-ratio percentages when you are purchasing an existing home, but not as much with a construction loan because of the risk level involved.


When you take out a mortgage for an existing loan, you start to make standard mortgage payments, which is principal, interest, taxes, and insurance right away – typically one month after closing, depending on the date that you closed. A construction loan, on the other hand, requires interest only payments for the construction portion of the loan, which is when the home is being built. These interest only payments are figured based on the amount of money that has been disbursed up until that point as well. This means that you will only pay a fraction of the “real” mortgage payment that you will begin paying once the loan transfers over into a permanent loan. Your interest only payment will also increase with every disbursement. If you have monthly disbursements, the payments will change every month, but if you have disbursements that are more spread out, the payment will not change as often. Once you transfer over into a permanent loan, however, you will be back to the standard, principal, interest, taxes, and insurance payment.


Once the building portion of the project is complete, your construction loan becomes due and payable in full because it is a balloon loan. This does not mean that you will have to come up with hundreds of thousands of dollars to pay the loan off; it means that you will have to get a permanent loan. This process is started right alongside the construction loan process but does require another closing. It is similar to refinancing an existing mortgage. You go through the qualification process again if you are using a different lender for the permanent financing or you may have to go through an abbreviated version of the qualification process if you use the same lender. They just need to ensure that there were no major changes in your income, employment, credit, or debt ratio while the home was being built. Once the permanent loan is ready, you close on it, which pays off the construction loan and puts you into your financing that will last you the next 15-30 years depending on the terms you chose for your new loan.

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