Construction Loans vs Mortgages: Key Differences You Should Know

Buying or building a new home is an exciting time. But it also requires making one of the biggest financial decisions of your life – how to finance it. You essentially have two main options:

1. Take out a traditional mortgage if purchasing an existing home

2. Get a construction loan if building a new home.

But what exactly is the difference between a construction loan and a mortgage? And how do you know which one is right for your situation?

In this comprehensive guide, we’ll break down the key differences between construction loans and mortgages. I’ll provide an overview of how each loan works, the pros and cons, interest rates, requirements, and steps for getting approved.

My goal is to arm you with the knowledge to make an informed decision on the best home loan for your needs. Whether you’re buying, building or renovating, understanding construction loans vs mortgages will pay off in the long run.

Let’s dive in!

What is a Mortgage?

First, a quick refresher on traditional mortgages. A mortgage is simply a loan used to finance the purchase of a home. The buyer makes a down payment on the house and borrows the rest through a mortgage.

Here are some key things to know about mortgages

• You receive the mortgage funds in one lump sum at closing to purchase an existing home from the seller

• Mortgages have fixed interest rates and a repayment term of usually 15 or 30 years. Your monthly payments go toward both principal and interest.

• The home itself serves as collateral for the loan. If you default, the lender can foreclose and take possession of the home.

• To qualify, you’ll need a good credit score, stable income, and a down payment of around 3-20% of the purchase price.

• Closing costs for origination fees and other expenses are typically 2-5% of the mortgage amount.

• Popular mortgage types include conventional, FHA, and VA loans. Each have different qualification standards.

Overall, mortgages allow qualified buyers to finance a home purchase with a low down payment and fixed, predictable monthly payments spread out over many years. It makes owning a home affordable.

Now let’s look at how construction loans work.

What is a Construction Loan?

A construction loan is specifically used to finance the building of a new home or other structure. Also called a construction mortgage, it provides funds for costs like:

• Purchasing land
• Paying contractors
• Buying building materials
• Obtaining permits

With a construction loan:

• You don’t receive the money all at once. The lender pays out funds in multiple stages as specific milestones are completed during the building phase.

• Interest rates are variable and payments often cover only interest while construction is ongoing. Once the home is finished, the loan may convert to a fixed-rate mortgage.

• The land and the home being built serve as collateral once there is value.

• Requirements typically include a credit score over 680 and a down payment of around 20% or more of the home’s expected value.

• Closing costs and fees are similar to a mortgage, often ranging from 2-5% of the loan amount.

• Construction terms are usually less than 18 months. The loan must be repaid in full or refinanced into permanent financing once the project is finished.

The staged funding and short-term flexibility of construction loans accommodate the home building process. But qualification standards tend to be stricter compared to mortgages.

Now that we’ve defined both loan types, let’s do a side-by-side comparison of the key differences.

Construction Loans vs. Mortgages: Key Differences

While construction loans and mortgages have some similarities, their distinct purposes result in notable contrasts:

Loan Purpose

• Mortgages finance the purchase of an existing home from a seller.

• Construction Loans finance the building of a new home that does not yet exist.

Collateral

• For a mortgage, the home being purchased serves as collateral from day one.

• With a construction loan, the vacant land and partially-completed home acts as collateral and is appraised during the building phase to approve draws.

Down Payment

• Mortgages often require a 3-20% down payment based on your credit, income, and loan type.

• Construction loans typically need at least a 20% down payment. Requirements are stricter because the lender takes on more risk.

Loan Terms

• Mortgage terms are usually long-term, such as 15 or 30 years.

• Construction loan terms are less than 18 months in most cases. You must repay it in full or refinance within that timeframe.

Interest Rates

• Mortgage rates are fixed for the entire repayment period, providing predictability.

• Construction loan rates are variable and float higher than mortgage rates by around 1% or more.

Payment Flexibility

• With a mortgage, you immediately pay principal and interest with each monthly payment.

• A construction loan may require interest-only payments while building is in progress, making payments more affordable.

Funds Disbursement

• Mortgages provide lump-sum funding upfront at the home purchase closing.

• Construction lenders pay funds incrementally at designated phases of the project after inspections, called “draws.”

Loan Conversions

• A mortgage cannot convert into anything else. You either pay it off or refinance it.

• Some construction loans can convert into permanent mortgages once the building is complete. This saves on costs.

As you can see, mortgages and construction loans have distinct differences that make each suitable for specific home financing needs. Now let’s look at the pros and cons of each option.

Construction Loan Pros and Cons

Construction loans offer some advantages but also have downsides to consider:

Pros

• Only pay interest while home is being built
• Draws provide more oversight and control over funds
• Can be converted to permanent mortgage
• Flexible terms and conditions

Cons

• Higher interest rates than mortgages
• Large down payment is required
• More complex application and administration
• Short repayment timeframe
• Variable rates fluctuate over the loan term
• Loan denied if project isn’t finished on time

Make sure the benefits of the construction loan align with your financial situation and that you can tolerate the risks and limitations.

Mortgage Pros and Cons

Similarly, weigh the mortgage pros and cons:

Pros

• Lower interest rates than construction loans
• Smaller down payment requirements
• Long repayment terms up to 30 years
• Fixed interest rates for stability
• Widely available with many options
• Can refinance into lower rate later

Cons

• Large amount of total interest paid over loan term
• Inflexible terms and conditions
• No control over funds disbursement
• Loan rejections more likely for low credit or income
• Closing costs and fees can be expensive

Again, consider both the advantages and disadvantages before deciding on traditional mortgage financing.

Getting Approved For Construction Loans vs Mortgages

The approval process also differs quite a bit between construction loans and mortgages:

Construction Loan

• Find a reputable home builder
• Get required permits and land surveys
• Provide detailed construction plans and specs
• Demonstrate strong finances with 20%+ down payment
• Submit to lender for review and approval
• Builder supervised draws after passing inspections
• Interest-only payments during building phase
• Repay/refinance balance once home is finished

Mortgage

• Compare mortgage rates and lenders
• Check your credit score and report
• Document income, assets, and down payment source
• Complete a loan application with a lender
• Allow property appraisal and underwriting
• Provide verification of identity and paperwork
• Close on mortgage and purchase home
• Begin making principal and interest payments

Getting approved for a construction loan tends to involve more legwork, oversight, and hurdles compared to a standard mortgage. Be prepared to jump through some extra hoops.

Finding the Right Construction Lender

Since the construction loan process is more relationship-driven, it pays to find the right lender. Here are some tips:

• Ask friends, realtors, and builders for references
• Search for lenders experienced in construction lending
• Review customer feedback and ratings
• Compare interest rates, terms, fees and requirements
• Look for responsive customer service and communication
• See if they offer loan conversions to mortgages

Taking the time to vet lenders will give you the best shot at construction loan approval and a smooth process.

Deciding Between Construction Loans and Mortgages

By now the key differences between construction loans and mortgages should be clear. But how do you decide which route to take?

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