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Getting ready to build your dream home? You’ll need to decide between a construction loan or a conventional loan. While both allow you to finance a home, there are some key differences between these two common types of mortgages.
In this comprehensive guide, we’ll break down what you need to know about construction loans and conventional loans so you can determine which is the better fit for your home building plans.
What is a Construction Loan?
A construction loan is a short-term loan used to finance the building of a new home. The funds can cover purchasing the land, materials, labor, permits and more.
With a construction loan, the money is disbursed in stages as each phase of the project is completed. An inspector will visit the site after each milestone to ensure work is progressing on schedule before approving the next draw of funds.
Construction loans typically have variable interest rates, meaning the rate can fluctuate over the course of the loan. Borrowers generally only need to pay interest during the construction period.
Once construction is complete, the construction loan must be paid off or converted to a permanent mortgage. Many lenders offer construction-to-permanent loans that automatically convert to a traditional fixed rate mortgage when the home is finished.
What is a Conventional Loan?
A conventional loan is a traditional mortgage loan that is not backed by a government agency like FHA or VA. Conventional loans are issued by private lenders like banks and credit unions
With a conventional loan, you receive the full loan amount upfront in a lump sum to purchase an existing home. Repayment on a conventional loan begins right away, with monthly payments covering both principal and interest.
Conventional loans tend to have fixed interest rates, meaning the rate stays the same over the entire term of the loan. Popular terms for conventional loans are 15 or 30 years.
Key Differences Between Construction Loans and Conventional Loans
Now that you understand the basics of construction loans and conventional mortgages, let’s look at some of the major ways these two home loan products differ:
Interest Rates
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Construction Loans: Tend to have higher interest rates than conventional mortgages, often 1% or more higher. Rates are variable and can fluctuate over the course of the loan.
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Conventional Loans: Typically have lower fixed interest rates that remain the same over the full repayment term.
Loan Term
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Construction Loans: Designed to be short-term, usually around 1 year or less. Meant to cover just the construction phase.
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Conventional Loans: Long-term loans, generally 15 or 30 year terms. Cover the full mortgage.
Collateral
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Construction Loans: The lender has no collateral because the home is not yet built. This makes them riskier.
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Conventional Loans: The home being purchased serves as collateral for the mortgage.
Payment Structure
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Construction Loans: Only interest payments are required during the construction phase. Principal is repaid at maturity.
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Conventional Loans: Monthly payments cover both principal and interest right from the start.
Disbursement of Funds
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Construction Loans: Funds are dispersed in stages as construction milestones are met. An inspector verifies progress.
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Conventional Loans: The full loan amount is paid out upfront in a lump sum to purchase the home.
Down Payment Requirements
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Construction Loans: Tend to require higher down payments, often 20% or more of the total project costs.
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Conventional Loans: Typically only require 3-20% down payment depending on the specific loan program.
Loan Qualifications
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Construction Loans: More stringent credit score and debt-to-income requirements compared to conventional loans.
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Conventional Loans: Easier to qualify for than construction loans in most cases.
Which is Better: Construction Loan or Conventional Loan?
There is no definitively “better” option between a construction loan and conventional mortgage. The right loan program depends entirely on your specific home financing situation and goals.
A construction loan is the better fit if:
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You want to build a custom home from the ground up.
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You want to act as your own general contractor to save money.
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You meet the higher credit, income and down payment requirements.
A conventional loan is likely the better choice if:
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You want to buy an existing or pre-built home.
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You don’t want to manage the construction process.
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You don’t meet construction loan requirements.
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You want fixed interest rates and monthly mortgage payments.
No matter which loan you choose, be sure to shop around and compare multiple lenders to find the best possible rates and terms. Consulting with a loan officer can also provide guidance on whether a construction loan or conventional mortgage is right for your needs.
Follow this comprehensive guide and you’ll be well on your way to financing your dream home, whether you decide to build new or buy pre-existing. The construction loan vs conventional loan decision is an important one, so weigh the pros and cons of each carefully as you map out your homeownership plans.
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How do construction loans work?
The initial term on a construction loan generally lasts a year or less, during which time you must finish the project. Because construction loans work on such a short timetable and are dependent on the project’s progress, you (or your general contractor) must provide the lender with a construction timeline, detailed plans and a realistic budget. Based on that, the lender will release funds at various phases of the project, usually directly to the contractor. Mortgage Construction loan statistics
- Construction loans typically require 20 percent down, at minimum.
- As of the second quarter of 2023, commercial and non-commercial construction loan volume totaled $488.54 billion, according to S&P Global Market Intelligence.
- Currently, the top five construction loan lenders, in terms of number of loans, are (in order): Wells Fargo, JP Morgan Chase, Bank of America, U.S. Bank and Bank OZK, reports S&P.
Construction Loans: What They Are and How They Work (IN DETAIL)
FAQ
Is it harder to get a construction loan than a mortgage?
Can conventional loan be used for construction?
Is it easier to get a loan to buy or build a house?
What is the difference between a conventional loan and a home loan?
Can a construction loan be converted to a mortgage?
Some construction loans can be converted to mortgages after your home is finished. Construction loans typically have tougher criteria than conventional mortgages for existing homes. If you can’t find the right home to buy, you might be thinking about building a house instead.
What is the difference between a construction loan and a mortgage?
Let’s delve into the differences between a **construction loan** and a **mortgage**: 1.**Construction Loan**: – **Purpose**: A construction loan is specifically designed to fund the building of a new
What are the different types of construction loans?
There are different types of construction loans available to borrowers, which are designed to suit various financial needs. With a construction-to-permanent loan, 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.
Should you buy a home with a conventional mortgage?
With a conventional mortgage loan, if you decided to purchase a home that needed some work, you would need to make sure it meets those requirements, and you must either pay out of pocket or get another loan to pay for the repairs.