Do You Need a Down Payment for a Construction Loan?

Taking on a major construction project like building a custom home can be an exciting yet daunting process One of the first things you’ll need to figure out is how you plan to pay for building your dream home.

Construction loans are a popular option that allow you to finance the building phase of your home But do you need to put any money down upfront with a construction loan?

The short answer is yes, you will likely need to make some form of down payment when taking out a construction loan. However, the specifics can vary quite a bit depending on factors like the lender, your credit scores, the type of construction loan and more.

Let’s take a closer look at what’s typically required for a construction loan down payment.

What is a Construction Loan?

Before we dive into down payments, it helps to have a basic understanding of what construction loans are.

Construction loans are short-term loans designed to cover the costs directly related to building a home. This includes things like:

• Land purchase
• Building materials
• Labor
• Permits
• Other construction costs

With a construction loan, funds are disbursed to the contractor in stages as milestones are met during the building phase. You’ll only pay interest on the amount disbursed, not the full loan amount.

Once construction is finished, the construction loan can be converted into a traditional mortgage. This longer-term loan allows you to pay off the home over 15-30 years.

Construction loans tend to have higher interest rates and require strong credit scores due to their risky nature. But they give you access to funds needed to make building a custom home possible.

Is a Down Payment Required for Construction Loans?

The majority of construction loan lenders will require some form of down payment. The specifics, however, can vary quite a bit.

Here are some key things to keep in mind regarding construction loan down payments:

• Down payments range from 5-20% – Most lenders require a minimum down payment of 5-20% of the total construction costs. The more you can put down, the better.
• 20% down avoids PMI – Putting down 20% or more allows you to avoid paying private mortgage insurance (PMI). This can save you hundreds per month.
• More is better for approval – Larger down payments improve your chance of approval and can result in better loan terms. Construction loans are riskier for lenders.
• Loan type matters – FHA and VA construction loans have different down payment rules than conventional loans. FHA is 3.5% down and VA is 0% down for qualified buyers.

The right down payment percentage for you depends on factors like your finances, construction budget, loan type, credit scores and debt-to-income ratio. Speak with a lender to determine the ideal amount to put down.

Why is a Down Payment Required?

It may seem frustrating that you have to put down a chunk of cash upfront in addition to taking out a construction loan. However, there are some important reasons a down payment is almost always required:

1. Shows you’re financially committed – Putting up some of your own hard-earned money upfront shows the lender you’re serious about the project and financially invested in it. This gives them more confidence in lending to you.

2. Lowers lender risk – Construction loans are riskier than traditional mortgages for lenders. Requiring a down payment helps lower their risk if something goes wrong. The more skin you have in the game, the better.

3. Helps you qualify for better terms – Coming in with a larger down payment can improve the chances you’ll qualify and result in lower rates and better terms from lenders.

4. Covers cost overruns – Even with diligent planning, construction costs can go over budget. A solid down payment gives a buffer for these unexpected overages.

Overall, the down payment requirement exists as much to protect you as the lender from taking on too much financial risk during the building process.

Construction Loan Down Payment Options

If coming up with a 10-20% down payment seems impossible, don’t panic. You still have options, including:

Lower your down payment – Most lenders will accept 5-10% down with good credit and financials. This avoids draining your savings.

Use liquid assets – Cash, stocks, bonds and mutual funds count as assets to satisfy down payment minimums. You don’t have to put down just cash.

Borrow against your current home – A cash-out refinance or home equity loan allow you to tap equity to get cash for the down payment.

Ask for seller assistance – Some builders or land sellers will provide down payment assistance in exchange for using their financing.

Explore down payment programs – State and local programs exist to help qualified buyers come up with down payments to build.

The bottom line is coming up with a construction loan down payment is often required, but many avenues exist for meeting this prerequisite if you’re short on funds. Get creative and ask your lender about all options.

What Goes Into the Down Payment?

Construction loan down payments aren’t just about the dollar amount. Most lenders will expect you to fulfill the down payment requirement in a specific way.

Here are some things to keep in mind with respect to satisfying a construction loan down payment:

• Land purchase – If you don’t already own the land, this must be paid upfront and counts toward your down payment contribution.

• Closing costs – Some closing costs can be rolled into the loan, but expect to pay closing costs out of pocket.

• Upfront fees – Any upfront loan fees must be paid at closing and factor into your down payment amount.

• Initial construction costs – You’ll likely need to pay permits, surveys and early material deliveries in cash at closing.

• Interest reserve – Most lenders require one year of interest payments to be reserved upfront as part of the down payment.

• Contingency fund – A 10-15% contingency fund for cost overruns is usually required in the down payment.

The down payment isn’t just a simple percentage. Be prepared for these additional cash requirements lenders expect you to pay at construction loan closing above and beyond the down payment percentage.

Down Payment Impact on Loan Terms

Putting down more upfront can make the rest of the construction loan process smoother and more affordable.

Here are some of the ways the down payment amount can impact the loan terms you receive:

Lower interest rate – Bigger down payments allow lenders to offer lower interest rates, saving money over the life of the loan.

Reduced fees – Paying more upfront can result in lower lender fees and closing costs.

Better loan-to-value (LTV) ratio – Lower LTVs reduce lender risk, opening up better loan options and rates.

Faster approval – Preapprovals can be issued quicker with large down payments and solid credit/financials.

Lower PMI – Putting down 20% avoids PMI, while less than 20% down results in higher monthly PMI costs.

Paying more upfront provides the lender confidence and shows you’re committed financially. This pays off via better construction loan terms down the road.

Alternatives if You Can’t Afford the Down Payment

For those who want to build their dream home but lack the savings for a hefty down payment, alternatives do exist. Here are a few options to explore:

Construction-to-permanent loan – This combines the construction loan and mortgage into one product with only one closing. Down payments as low as 5% may be accepted. However, this can be a more expensive option overall.

Owner-builder construction loan – If you have contracting experience, this allows you to act as your own GC. Some lenders offer these with lower down payments.

Land loan + construction loan – Separate loans allow you to finance the land purchase first with little-to-no down payment, followed by a construction loan for building.

FHA, USDA or VA loan – Government-backed construction loans have lower down payment requirements, even 0% down for veterans.

State/local down payment assistance – Many programs exist at the state and local level to help qualified applicants come up with down payments.

Construction loans provide a pivotal stepping stone to building a custom home. And while the down payment hurdle can seem high, many options exist for limited budgets. Do your homework and get creative to make your dream a reality, even with limited funds.