Do Construction Loans Require a Down Payment?

When it comes to building your dream home from the ground up, construction loans are a popular financing option. But unlike a traditional mortgage, construction loans have some unique requirements – including when it comes to down payments. So do construction loans require a down payment?

The short answer is yes, construction loans do generally require a down payment. The specific down payment amount can vary depending on factors like the lender and loan program. But having a down payment is an essential part of getting approved for construction financing.

As a construction loan expert, I’m often asked by clients how much they’ll need to put down to get started on their custom build. While every situation is different, in this article I’ll break down the key things to know about construction loan down payments.

Why a Down Payment Is Required

Construction loans are considered riskier than conventional mortgages by lenders. That’s because with a construction loan there’s no completed home or asset yet that can act as collateral. All the lender has to secure the loan is the land itself.

Requiring a sizable down payment helps offset some of this risk The more money you put down upfront, the less chance there is of you defaulting on the loan if things go sideways A 20% down payment on a construction loan is common.

Down payments also show the lender you’re financially committed to the project. Putting your own “skin in the game” demonstrates you have the resources to cover some of the home building costs yourself.

Typical Down Payment Amounts

As mentioned above, many lenders look for a 20% down payment on construction loans. However, it’s possible to qualify for construction financing with less. Here are some typical down payment amounts:

• 20% down: The most commonly required amount. With 20% down, you avoid having to pay private mortgage insurance (PMI).

• 10-15% down: Some lenders may approve a construction loan with 10-15% down. You’ll likely have to pay PMI with this option.

• 3-5% down: Certain government construction loan programs, like USDA and VA loans, allow down payments as low as 3-5%. These programs can make building more affordable.

• Owner-builder loans: For those with construction experience, owner-builder loans are possible with 10% down or less in some cases. But approval is harder to obtain.

The stronger your credit, income, and overall financial profile, the lower your required down payment may be in many cases. Talk to multiple lenders to see what programs you qualify for.

I always recommend my clients aim for at least a 20% down payment if possible. This gives you the best rates and terms, and ensures loan approval. Anything less than 20% down requires an exceptionally strong application.

How the Down Payment Works

With a mortgage, you pay your down payment upfront at closing and receive the loan amount in one lump sum. Construction loans are different – the down payment is paid in stages as the build progresses.

Here’s a quick rundown of how the down payment works with construction financing:

• You pay a portion of the down payment at land closing when purchasing the lot. This is often 10-20% of the total down payment.

• The lender will retain the remaining down payment funds in an escrow account.

• As construction moves forward, the lender releases incremental down payment amounts to the builder per the draw schedule.

• By the final payment, your total down payment funds will be fully disbursed.

• If construction comes in under budget, any leftover down payment money is returned to you.

The down payment is paid out gradually to ensure there are adequate funds to complete each phase. Your builder shouldn’t receive money until work is completed per the contract.

Saving up for Your Down Payment

Given the large down payments required, saving up adequate funds is one of the biggest challenges for construction loan borrowers. Here are some tips on how to beef up your down payment savings:

• Start saving early – set up automatic monthly transfers into your down payment fund.

• Cut discretionary spending to find more money to set aside.

• Take advantage of down payment assistance programs if you qualify.

• Consider borrowing from your 401(k) through a loan or early withdrawal. This comes with some caveats, so learn the rules first.

• Ask family members to gift funds for your down payment. Lenders allow this with proper documentation.

• If you have home equity, a cash-out refinance can provide down payment cash. But make sure you can afford the higher monthly payment.

• A 0% intro APR credit card can help you earn rewards on down payment spending while paying no interest for 12-18 months. Just be sure you pay off the balance before the regular APR kicks in.

Saving up 20% down or more for a construction project takes diligent planning. But the good news is there are many options to help you achieve your down payment goal faster.

Alternatives If You Can’t Afford a Large Down Payment

Some prospective home builders simply don’t have the funds for a 20% down construction loan down payment. But that doesn’t necessarily mean you have to abandon your dreams of building a custom home. Here are a few alternative options to look into:

Lower down payment loan programs – As mentioned above, VA and USDA loans allow down payments as low as 3-5% for qualifying borrowers. FHA also offers construction loans with 3.5% down.

Owner-builder construction loans – If you have contracting experience, you may qualify for owner-builder financing with less than 20% down. This route is trickier but can provide more flexible terms.

Seek down payment assistance – Nonprofit groups like Habitat for Humanity provide down payment help for lower income buyers. Additionally, some state and local governments offer down payment assistance programs. These can take off 5-15% or more of your required down payment.

Wait and save – This might not be what you want to hear. But taking an extra year or more to beef up your down payment savings could be prudent if buying today financially stretches you too thin. Slow and steady wins the race.

Consider alternatives to building – If you absolutely can’t manage the down payment, carefully weigh if buying an existing home or continuing to rent while saving might be a better call for now financially. You can always revisit building later on.

As you can see, lack of down payment funds doesn’t necessarily have to derail your construction dreams forever. Tap into the many options that can help buyers with limited means achieve homeownership too. With creativity and determination, you can likely find a workable path forward.

Using Equity If You Already Own a Home

If you’re hoping to build but already own your current home, you may be able to leverage your existing home equity to come up with the down payment.

Here are two options for using home equity for a construction loan down payment:

Cash-out refinance – With a cash-out refinance of your current mortgage, you can pull equity out of your home. The funds from the refinance can then be used to make the down payment on your construction loan.

Home equity loan – This is a second loan that uses your equity as collateral. The loan proceeds can be used for any purpose – including financing your new home build.

Before tapping equity, be sure you can comfortably handle the higher monthly payments that come with these options. And consult a tax pro – you may owe capital gains taxes in some cases when tapping large equity amounts.

But when used judiciously, leveraging equity you’ve built up can be a game changer in assembling your construction down payment.

Down Payment Takeaways

In a nutshell, here are the key takeaways when it comes to down payments for construction loans:

• A down payment of around 20% is typically required, but 10-15% may be possible based on your financial profile and lender practices.

• The down payment is paid out in stages rather than upfront in one lump sum.

• Start saving for your down payment as soon as possible – it takes most people years to accumulate 20% down or more.

• Explore alternative programs and assistance if you can’t afford 20% down but are still hoping to build.

• Those with existing home equity can leverage it through options like cash-out refinances and home equity loans to access down payment funds.

While construction loans have steeper down payment requirements, don’t let a lack of savings today deter you from pursuing your home building dreams. With diligent saving and smart financing, you can make your vision of a custom built home come true.