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Construction loans allow you to finance the building of a new home from the ground up. But how much do these specialized loans actually cost? In this comprehensive guide, we’ll break down the typical costs associated with construction loans so you can determine if one is right for your situation
What Is a Construction Loan?
Before we dive into the costs, let’s quickly review what a construction loan is. A construction loan is a short-term loan used to finance the building of a new home. The funds can cover purchasing the land, obtaining permits paying for materials and labor, and more.
Construction loans are different from traditional mortgages in a few key ways:
- They are shorter in duration, usually 12-18 months to cover the construction period.
- You don’t make payments on the full loan amount upfront. Instead, funds are issued in draws as each stage of construction is completed.
- Interest rates are variable and tied to an index like the prime rate. They are typically 1% higher than mortgage rates.
At the end of the construction period, the loan may either be paid off or converted into a permanent mortgage. Now let’s look at the major costs involved.
Land Acquisition Costs
One of the first costs you’ll encounter is purchasing the land if you don’t already own it. The land purchase price will vary drastically depending on the location, size of the lot, and other factors. In expensive real estate markets, the land alone could be several hundred thousand dollars.
In addition to the purchase price, you’ll also have closing costs on the land purchase, including:
- Title insurance
- Legal fees
- Recording fees
- Transfer taxes
Plan for these closing costs to add 3-5% onto the purchase price. If the land costs $100,000, you’ll pay $3,000-5,000 extra in fees at closing.
Construction Loan Fees
When you actually obtain the construction loan, there are a number of fees to be aware of:
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Origination fee: This upfront fee is usually 1-2% of the loan amount. On a $300,000 loan, expect to pay $3,000-6,000.
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Application fee: Lenders may charge a fee just to apply, which can range from $100-500.
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Processing fee: Costs for underwriting and processing the loan, often $200-500.
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Appraisal fee: The lender will require an appraisal of the land, costing $300-500 in most cases.
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Inspection fees: The lender will send an inspector to evaluate each stage of construction before releasing additional funds, which may cost $200 or more per inspection. Expect several inspections throughout the build.
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Legal fees: You may need to pay $1,000 or more for the lender’s attorney to review the loan agreements.
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Title fees: As with the land purchase, you’ll need to pay for title insurance and related title services on the construction loan, which could cost over $1,000.
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Recording fees: The lender will need to record the loan documents with the county, which may cost $50-150.
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Credit report fee: The lender will pull your credit report, which typically costs $20-50.
In total, these various fees could easily amount to $5,000-10,000 on a typical construction loan. Be sure to factor them in when budgeting for the project.
Interest Costs
One of the largest costs with a construction loan is interest. As noted above, construction loans feature variable interest rates, so your actual interest costs will depend on how rates trend during the loan term.
For example, if you obtained an 18-month construction loan for $300,000 at 6% interest, your total interest costs would be:
- Loan amount: $300,000
- Interest rate: 6%
- Loan term: 18 months (1.5 years)
- Annual interest at 6%: $18,000
- Total interest for 18 months = 1.5 years x $18,000 = $27,000
This example illustrates how interest can add substantially to the overall cost of the loan. Shop around for the best possible rate when applying to keep your interest expenses lower.
Contingency Fund
Industry experts recommend setting aside a contingency fund equal to 10-20% of the total construction budget. This provides a financial cushion in case the project runs over budget due to unforeseen costs.
For instance, if your construction budget is $300,000, you may want to add a $30,000-60,000 contingency fund. This would increase the loan amount, but give you breathing room to handle cost overruns.
Interest Reserve
Some lenders allow you to build an interest reserve into the loan amount. This reserve covers the interest payments during the construction phase so you don’t have to pay out of pocket.
For the example above with 18 months of interest costing $27,000, you could add that to the loan amount upfront and tap into that reserve to make the monthly interest payments.
Conversion Fees
If you choose to convert the construction loan into permanent financing, there are added conversion costs:
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Origination fee on new loan: Expect to pay another 1-2% of the new mortgage amount.
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Appraisal fee: The lender will require an updated appraisal of the completed home, typically $300-500.
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Credit report fee: Again, the lender will pull a new credit report, costing $20-50.
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Recording fee: You’ll pay to record the new mortgage, which may cost $50-150.
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Title insurance: As the home is now complete, you’ll need an updated title policy for around $1,000.
Converting the loan can add $2,000-4,000 in extra fees. A construction-only loan avoids these conversion costs but requires qualifying for a new mortgage.
Total Costs
To summarize, the total costs may include:
- Land purchase price and closing costs
- Construction loan fees ($5,000-10,000)
- Interest payments
- Contingency fund (10-20% of construction budget)
- Interest reserve (optional)
- Conversion fees, if applicable ($2,000-4,000)
On a $300,000 construction loan, total costs can easily exceed $100,000. Carefully evaluate what you can afford before moving forward with a construction loan.
Ways to Save on Construction Loan Costs
If the costs seem daunting, here are a few tips to reduce construction loan expenses:
- Shop around for the best interest rate to minimize interest costs
- Seek out lenders that offer discounted origination fees or waive some fees
- Pay for inspections/appraisals yourself to avoid markups from the lender
- Put down a larger down payment if possible to lower the loan amount
- Compare construction-only vs. construction-to-permanent loans to see which is more affordable
The Bottom Line
Construction loans allow you to build your dream home, but they come at a price. From purchasing the land to paying interest and fees, your total costs can easily exceed $100,000. Carefully weigh the costs against your budget and explore ways to secure the best possible deal on your construction loan. With prudent planning, you can make your ideal home a reality.
Construction loans vs. traditional mortgages
Beyond the cost and repayment timeline, construction loans and mortgages have a few main differences:
- The funds distribution: Unlike mortgages and personal loans that provide funds in a lump-sum payment, the lender pays out the money for a construction loan in stages as work on the new home progresses. These draws tend to happen when major milestones are completed — for example, when the foundation is laid, or the framing of the house begins.
- The repayments: With a mortgage, you start paying back the principal and interest right away. With construction loans, your lender will typically expect you to make interest payments only during the construction stage. Additionally, borrowers are typically only obligated to repay interest on any funds drawn to date until construction is completed.
- Inspection/appraiser involvement: While the home is being built, the lender has an appraiser or inspector check the house during the various construction stages. As the work is approved, the lender makes additional payments to the contractor, known as draws. Expect to have between four and six inspections to monitor the progress.
- Requirements: Construction loan requirements include being financially stable and having the ability to make a down payment. Lenders also want to see a construction plan, which you can read more about below.
- Interest rates: Construction loan interest rates are typically higher than traditional mortgage rates. This is often because you’re not providing collateral to back the loan, which means the lender is taking on more risk.
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Use A Construction Loan To Build A House?
FAQ
How to calculate a construction loan?
Is a construction loan more expensive than a mortgage?
What is loan to cost in construction?
Is a construction loan a good idea?
What is a construction loan calculator?
Our construction loan calculator is a tool that helps you estimate the financials of your construction project. It can determine your monthly payments during the construction project, and the monthly mortgage payments after the construction is done. It can also estimate FHA, USDA, and VA construction loans.
What is a construction loan?
A construction loan is a short-term loan (one year or less) that turns into a longer, more conventional mortgage when building is complete. The larger part of the loan, usually 15 or 30 years, begins after the construction is finished. With a construction loan secured, you will receive installment payments for that first year of building.
How much money do you need for a construction loan?
Borrowers typically need a down payment of at least 20% for a construction loan, but this can vary by lender. You should have enough income to cover payments on your current debts and the new construction loan. Lenders typically require a DTI ratio no higher than 45% for construction loans.
What are the types of construction loans?
There are different types of construction loans, including a construction-to-permanent loan, where you borrow money to pay for the cost of building your home. Once the house is complete and you move in, the loan is converted to a permanent mortgage.