Closing Costs on Construction Loans: A Complete Guide for 2023

Construction loans allow future homeowners to finance the building of a new house from the ground up. These loans provide the capital necessary to purchase land, obtain permits, and pay for materials and labor over the course of the construction project.

While construction loans make building a custom home possible, they also come with their own set of closing costs and fees. As with traditional mortgages, the closing costs on a construction loan can really add up. As such it’s important for borrowers to understand these charges and prepare for them when budgeting for their new home build.

In this comprehensive guide, we’ll break down the common closing costs associated with construction loans so you know what to expect before signing on the dotted line

What are Closing Costs on a Construction Loan?

Closing costs refer to the various fees charged by lenders and third parties to finalize and fund a construction loan. Much like closing costs on a mortgage, construction loan closing costs may include:

• Origination fees
• Application fees
• Processing fees
• Underwriting fees
• Appraisal fees
• Credit report fees
• Recording fees
• Title insurance fees
• Taxes
• Inspection fees
• Legal fees
• Interest reserves
• Contingency reserves

These costs cover the lender’s work in evaluating your application, processing your loan, and securing their investment. Third-party fees like appraisal and inspection costs also factor into the total closing costs on a construction loan.

While mortgages and construction loans share some of the same closing cost items, the amounts can vary significantly between loan types. Construction loans tend to have higher closing costs overall due to the increased time commitment and risk involved for lenders.

Average Closing Costs on a Construction Loan

Construction loan closing costs can range from 2% to 5% of the total loan amount on average. So for a $300,000 construction loan, you may pay $6,000 to $15,000 in closing costs.

Here’s a breakdown of typical closing costs for a $300,000 construction loan:

• Origination fee: 1% to 2% of loan amount ($3,000 to $6,000)
• Application fee: $50 to $100
• Credit report fee: $20 to $50
• Appraisal fee: $300 to $500
• Title insurance fee: $1000 to $1500
• Recording fees: $50 to $150
• Legal fees: $500 to $1000
• Inspection fees: $300 to $500
• Interest reserve: 1% to 3% of loan amount ($3,000 to $9,000)
• Contingency reserve: 5% to 10% of loan amount ($15,000 to $30,000)

Total average closing costs: $23,220 to $49,300

As you can see, interest and contingency reserves make up a significant portion of closing costs on construction loans. These reserves ensure funds are available to cover unanticipated delays or cost overruns during the build.

Factors That Impact Closing Costs

Several factors can cause construction loan closing costs to be higher or lower than average:

• Loan amount – Closing costs are typically expressed as a percentage of the total loan amount. The higher the loan amount, the greater the total closing costs.

• Credit score – Borrowers with higher credit scores usually qualify for lower interest rates and fees overall. Those with poor credit pay more.

• Loan term – Longer loan terms tend to have higher interest reserves and overall closing costs.

• Type of lender – Big banks typically charge higher fees than credit unions and online lenders.

• Location – closing costs can vary by state based on local taxes, recording fees, and title insurance rates.

• Custom builder vs general contractor – using a general contractor instead of a custom builder may increase fees for construction monitoring.

Tips for Reducing Closing Costs

While some closing costs on a construction loan are unavoidable, here are a few tips for keeping these charges to a minimum:

• Shop around – Compare quotes from multiple lenders to find the best rates and lowest fees. Online lenders tend to offer more competitive pricing than major banks.

• Ask about discounts – See if the lender offers any discounts for borrowers who have an existing relationship with the bank or meet certain criteria.

• Buy down the interest rate – Paying points upfront to get a lower interest rate will reduce interest reserves needed at closing.

• Put down a larger down payment – This lowers the amount you need to borrow, which in turn lowers overall closing costs.

• Choose a shorter loan term – Opting for a 12-month construction loan instead of 18 months can significantly reduce interest reserves needed.

• Pay for your own inspections – Paying for inspections yourself instead of financing them into the loan avoids markups by the lender.

Are Closing Costs on Construction Loans Tax Deductible?

Most of the closing costs incurred on a construction loan are not tax deductible, unfortunately. You cannot deduct standard fees like origination charges, application fees, or title insurance premiums.

However, you may be able to deduct some closing costs associated with obtaining the construction loan, including:

• Points paid to buy down the interest rate
• Legal fees for loan-related documents
• Appraisal fees
• Credit report fees

These fees can be deducted in the tax year the construction loan closes. You would claim them as itemized deductions on Schedule A of your tax return. As with mortgage points, you must amortize the value of the deductions over the loan term.

How are Closing Costs Paid on Construction Loans?

For construction loans, closing costs are typically divided into two payments:

• Initial payment – At the time of closing, you pay non-recurring fees like origination charges, appraisal fee, credit report fee, and title insurance premiums.

• Ongoing payments – Interest and contingency reserves are built into your monthly payments over the loan term.

By splitting closing costs this way, it reduces the upfront cash needed at closing while providing funds needed for potential cost overruns throughout the construction project.

Most lenders require the initial closing costs to be paid using your own funds or the construction loan proceeds. If your loan amount exceeds the actual construction costs, the surplus funds can be applied toward closing costs as well.

Are Closing Costs Refunded if Loan Denied?

If your construction loan application is denied after you’ve already paid some upfront fees, you may be able to get certain costs refunded. Lenders are required to refund any fees deemed as “application fees”, such as:

• Application or origination fees
• Credit report fees
• Appraisal fees
• Tax service fees

However, other charges for third-party services like title work and legal fees are usually not refundable. Be sure to ask the lender ahead of time about their refund policy to avoid surprises.

The Bottom Line

Closing costs are a significant factor to account for when budgeting for a construction loan. Taking the time to understand these charges and shop around for the best rates can help minimize the impact on your finances. Speak with multiple lenders, look for available discounts, and reduce non-essential costs where possible. This helps ensure you start off your new home build on the best financial footing.