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If you’re looking to build a new home from the ground up, you’ll need to understand the key differences between a building loan and a traditional home loan. While they may seem similar on the surface, these two types of loans have some distinct differences that you should be aware of before choosing the right financing option for your new construction project.
In this comprehensive guide, we’ll break down everything you need to know about building loans and home loans, including:
- What is a building loan?
- What is a home loan?
- The key differences between building loans and home loans
- Pros and cons of each type of loan
- Eligibility and requirements
- Interest rates and fees
- The loan process
- Frequently asked questions
Let’s dive in!
What is a Building Loan?
A building loan, also known as a construction loan, is a short-term loan used to finance the construction of a new home. These loans provide funding for all phases of construction, from purchasing the land to paying for materials and labor.
Here are some key characteristics of building loans:
- Temporary financing that covers the construction period, usually around 6-12 months
- Funds are disbursed in stages as construction milestones are met
- Only pay interest on the money that has been disbursed
- Once construction is complete, the loan must be converted into permanent financing
- Typically have higher interest rates than traditional mortgages
- Require 20% down payment in most cases
Building loans allow you to customize and build your dream home from scratch. However, they can be riskier for lenders since the home is not yet completed, which is why interest rates tend to be higher.
What is a Home Loan?
A home loan also known as a mortgage, is a long-term loan used to finance the purchase of an existing home. Traditional home loans like FHA VA, and conventional loans fall into this category.
Here are some characteristics of home loans:
- Long-term financing that can last 15-30 years
- Funds are dispersed in a lump sum at closing to purchase a completed home
- Make monthly payments that include principal, interest, taxes, and insurance (PITI)
- Interest rates are generally lower than construction loans
- Smaller down payments may be allowed (as low as 3.5% with an FHA loan)
Home loans allow buyers to finance a move-in ready home They come with lower interest rates and more flexible down payment options But you are limited to purchasing an existing property.
Key Differences Between Building Loans and Home Loans
Now that we’ve covered the basics. let’s look at some of the major differences between these two types of loans
Loan Term
- Building loans are short-term, usually 6-12 months
- Home loans are long-term, usually 15-30 years
Use of Funds
- Building loans fund construction of a new home
- Home loans fund purchase of an existing home
Interest Payments
- Building loans accrue interest on disbursed funds
- Home loans accrue interest on the full loan amount
Down Payment
- Building loans typically require 20% down
- Home loans allow lower down payments in many cases
Interest Rates
- Building loans tend to have higher interest rates
- Home loans often have lower interest rates
Loan Conversion
- Building loans must be converted to permanent financing
- Home loans do not require conversion
Risk Factor
- Building loans are riskier since the home is unfinished
- Home loans are lower risk with a completed property
As you can see, there are some clear distinctions between these two loan products in terms of their structure, costs, and overall process. Keep these differences in mind as you decide which route is right for your unique home financing needs.
Pros and Cons of Building Loans
Pros
- Design and build a custom home tailored to your needs
- Potentially add more value by customizing finishes
- Only pay interest on disbursed funds during construction
- Lock in an interest rate upfront for permanent financing
Cons
- Higher interest rates than home loans
- Must be converted into permanent financing later
- Need to commit to a construction timeline
- Cost overruns can happen if not budgeted properly
- Require a larger down payment, usually 20%
Pros and Cons of Home Loans
Pros
- Lower interest rates than building loans
- Move into a completed property right away
- Potentially lower down payments on FHA, VA, USDA loans
- No construction phase or timeline to manage
- May be able to finance closing costs
Cons
- Cannot customize finishes or layout
- Limited to purchasing existing homes on the market
- Monthly payments include principal, interest, taxes and insurance
- Closing costs may need to be paid upfront
Building Loan Requirements
Building loans have stricter eligibility guidelines than home loans. Here are some typical requirements:
- Minimum credit score of 620
- Down payment of at least 20%
- Debt-to-income ratio below 43%
- Stable income and employment history
- Detailed construction plans and specs
- Approved builder
You’ll also need to be approved for permanent financing that the construction loan can be converted into once the home is complete. This is essentially like applying for two mortgages.
Home Loan Requirements
Home loans have more flexible requirements:
- Minimum credit scores vary by loan type, as low as 580 for FHA
- Lower down payments allowed, including 3.5% for FHA
- Debt-to-income ratios up to 50%
- Stable income and employment
- No construction plans needed
While requirements are more lenient, you will need to show you can afford the full monthly payments on a completed home.
Interest Rates
Construction loans tend to have higher interest rates than home loans. Here are some averages:
- Construction loans: 6-8% interest rate
- Conventional loans: 4-6% interest rate
- FHA loans: 3.5-4.5% interest rate
- VA loans: 3-4% interest rate
Keep in mind construction loans are variable rate. The rate you receive will depend on your financial profile and credit score. Home loans often allow you to lock in a low fixed rate.
The Building Loan Process
If you decide a construction loan is right for your new build, here is an overview of the process:
- Choose a qualified builder
- Find a lender and apply for pre-approval
- Submit all required documentation
- Be approved for the construction loan
- Purchase land and finalize building plans
- Initial loan funds will be dispersed to start construction
- Loan funds disbursed in installments as milestones are met
- Home construction completed
- Obtain certificate of occupancy
- Convert loan into permanent financing
It’s critical to find a trustworthy builder and realistic budget. Delays or cost overruns during construction can lead to higher fees and interest rates.
The Home Loan Process
The process of obtaining a traditional home loan is much simpler:
- Get pre-approved for financing
- Shop for an existing home and make an offer
- Enter escrow period after offer is accepted
- Submit documentation and complete loan underwriting
- Receive final loan approval
- Close on the home and take ownership
- Begin making monthly mortgage payments
With an existing property, there is no construction phase to manage. However, you need to find a home that fits your needs since customization is limited.
Frequently Asked Questions
Can I get a building loan for a home remodel?
Remodel loans like the FHA 203(k) allow you to finance renovations to an existing home you purchase. However, they cannot be used for ground-up construction.
What happens if construction delays exceed my loan term?
You may face penalties and a higher interest rate if the build is not completed within the loan term. Some lenders may allow short extensions for unforeseen delays.
Can I use leftover building loan funds for furnishings?
No, leftover funds are applied as a principal reduction to lower the permanent mortgage balance. The loan is strictly for construction costs.
What are the closing costs on a building loan?
Closing costs are similar to a home purchase, including fees for the appraisal, loan origination, title insurance, and more. They typically range from 2-5% of the total loan amount.
Should I pay discount points on a building loan?
Discount points allow you to buy down the interest rate. This can save money long-term if you plan to keep the permanent financing for several years.
What happens if the builder goes over budget?
You will need to cover any shortfalls with the builder directly. The lender will not disburse funds beyond the original loan amount.
The Bottom Line
Building a custom home is an exciting endeavor that allows you to create your ideal living space. But before choosing a building loan, be sure
What are construction loans?
Construction loans are loans that fund the building of a residential home (aka a stick-built house), from the land purchase to the finished structure. Common types are a standalone construction loan — a short-term loan (generally with a year-long term) — which only finances the building phase, and a construction-to-permanent loan, which converts into a mortgage once the construction is done. Borrowers who take out a standalone construction loan often get a separate mortgage to pay it off when the principal falls due.
You can use a construction loan to cover such costs as:
- The land
- Contractor labor
- Building materials
- Permits
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.