Construction Loans vs Home Loans: Key Differences You Should Know

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Buying or building a home is likely one of the biggest financial decisions you’ll make in your life. When purchasing an existing property a traditional home loan or mortgage is typically used to finance the transaction. However, if you want to build a new home from the ground up, you’ll need a different type of financing called a construction loan.

Construction loans and traditional home loans share some similarities, but there are also some key differences between these two common types of housing loans that you should understand before choosing the best option for your situation. In this article, we’ll compare and contrast construction loans vs home loans so you can make an informed decision when it comes time to finance your new living space.

What is a Construction Loan?

A construction loan, also known as a construction mortgage, is a short-term loan used to finance the building of a new home. Construction loans provide financing through the completion of the building project, which typically takes 6-12 months.

With a construction loan, funds are distributed incrementally in stages as construction milestones are met. An inspector verifies completion of each milestone before the lender releases additional funds to the builder.

Construction loans can either be construction-only loans, where the balance must be paid off after the home is completed, or construction-to-permanent loans that convert into a traditional mortgage once construction is finished.

What is a Home Loan?

A home loan or mortgage, is a loan used to finance the purchase of an existing home. The most common home loans are

Conventional loans – Given by private lenders without government backing. Typically require 10-20% down payment.
FHA loans – Insured by the Federal Housing Administration. Only require 3.5% down.
VA loans – Backed by the Department of Veterans Affairs for eligible service members. Require no down payment.
USDA loans – From the U.S. Department of Agriculture for properties in rural areas. No down payment needed.

With a home loan, you receive the full loan amount upfront upon closing to purchase the completed home. The loan is then repaid with monthly principal and interest payments over a set repayment term, usually 15-30 years.

Key Differences Between Construction Loans and Home Loans

While both provide financing for housing needs, there are some notable differences between getting a construction loan vs a home loan:

Loan Purpose

Construction Loans – Meant for building a new home from the ground up. Covers land purchase, construction costs, labor, materials, permits, etc.
Home Loans – For buying an existing, completed property. Funds go directly to purchase the finished home.

Loan Terms

Construction Loans – Short-term loan, generally 1 year or less to finish construction.
Home Loans – Long-term loan, typically 15-30 year repayment terms.

Interest Rates

Construction Loans – Tend to have higher variable interest rates, 1% or more higher than home loans. Rates fluctuate with the prime rate.
Home Loans – Most often have lower fixed interest rates locked in for the full repayment term.

Collateral

Construction Loans – Unsecured loan since home is not yet built. Lender takes on more risk.
Home Loans – Secured loan with the home itself as collateral. Lower risk for lenders.

Fund Disbursement

Construction Loans – Funds issued in installments after passing inspection milestones.
Home Loans – Entire loan amount disbursed upfront in a lump sum.

Loan Repayment

Construction Loans – Only interest payments, no principal, required during construction.
Home Loans – Monthly payments of principal + interest start right after closing.

Credit Score Requirements

Construction Loans – Tend to require higher credit scores, 680+ on average.
Home Loans – Minimum scores around 600-620 for government-backed options.

Down Payment Requirements

Construction Loans – Typically need 20% down payment at minimum.
Home Loans – Down payments as low as 3.5% available with government programs.

Fees/Closing Costs

Construction Loans – Single set of closing costs on construction-to-permanent loans. Double fees for construction-only.
Home Loans – One set of upfront fees/closing costs.

Inspections

Construction Loans – Multiple (4-6) inspections required during the building process before funds released.
Home Loans – Typically only 1 inspection required for home appraisal before closing.

How to Choose: Construction Loan vs Home Loan

When trying to decide between getting a construction loan or home loan, here are some key factors to consider:

Your budget – Construction loans typically require more money upfront for the down payment. Home loans offer lower down payment options.
Loan costs – Closing fees, interest rates, and repayment terms all impact your total loan cost. Compare total costs closely.
Your credit – Need a good credit score for construction loans. Home loans allow lower scores.
Customization – Construction loans allow you to customize building plans. Home loans finance existing homes.
The process – Construction loans require managing builders, permits, inspections. Home loans are a simpler buying process.
Timeframe – Construction takes 6-12 months. Home loans allow you to move in quickly after closing.

Think about your specific financial situation, housing goals, and lifestyle needs as you weigh construction loan vs home loan options. Connect with experienced lenders to get rate quotes and home buying advice customized to your circumstances.

Getting Started with Construction and Home Loans

Whether you’ve decided on getting a construction loan to build new or a home loan to buy existing, it’s wise to start researching lenders and pre-qualifying early in the process. This helps you understand what you can afford and prevents delays later on.

Here are some tips for getting started:

Check your credit score and report for any needed improvements.
Calculate your target home budget based on income, debts, and down payment savings.
Gather required documents like income statements, tax returns, and bank statements.
Research trusted mortgage lenders and builders in your local area. Ask friends for referrals.
Apply for pre-approval/pre-qualification with multiple lenders to compare rates and programs.
Connect with a real estate agent experienced in new construction if going the construction loan route.

The more informed you are about the loan process, the smoother it will be to secure financing for your new dwelling, whether you decide to build or buy. Weigh the pros and cons of construction loans vs home loans carefully based on your own home ownership goals.

The Bottom Line

Construction loans and home loans both have their advantages and disadvantages. If you want to build a custom home from the ground up, a construction loan allows you to finance the entire process. Home loans provide an easier path to quick homeownership by financing an existing property.

Carefully assess your financial situation and home preferences before deciding which route is the best fit. Be sure to shop multiple lenders to find the most favorable loan terms and interest rate for your budget. With the right loan choice, you’ll be on your way to enjoying your beautiful new living space sooner than you may think.

construction loan vs home loan

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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Construction loans are short-term loans that you can use to build a new home.
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. Financing this type of project is somewhat different than getting a mortgage to move into an existing property. Instead of a mortgage, you take on a construction loan (also known as a construction mortgage). Here’s what to know about construction loans.

Use A Construction Loan To Build A House?

FAQ

Is it harder to get a construction loan than a mortgage?

Because a new home project is riskier than buying an existing residence, construction mortgages can be more difficult to obtain and carry higher rates than regular home mortgages. Still, there are plenty of lenders out there—both specialists in home loans and traditional banks.

Is it easier to get a loan to buy or build a house?

Easier to finance: Existing homes are less risky for mortgage lenders, so they often have better rates and terms for financing. You may not have to jump through as many hoops or make as large of a down payment as you might on a custom home.

Why are construction loans risky for lenders?

While there are many risks involved in construction lending, one major one is non-completion of the project or house within the specified period. Funds can run out before the end of the construction project if the budget is improperly managed. This scenario is common to all parties involved.

What’s the difference between a home loan and a building loan?

Construction loans are short-term—usually no more than a year. They are typically interest only payments based on the amount you have advanced on your loan. Mortgages are long term and the money is received in a lump sum. The payments typically consist of principal and interest.