How Much Down Payment Do You Need for a Construction Loan?

Taking on the process of building a custom home can be an exciting yet daunting task. While rewarding, a major undertaking like constructing a home requires careful planning and budgeting. One of the most critical steps is securing financing, and for that, you’ll need a construction loan.

Construction loans allow you to finance the building of a new home on property you already own. But they differ greatly from traditional mortgages in both how they work and qualification requirements. A key difference is that construction loans typically require a larger down payment, often 20% of the total cost

So how much down payment do you actually need for a construction loan? What factors determine the amount? Let’s take a deeper look.

Why Do Construction Loans Require a Down Payment?

Down payments are common requirements for most types of loans, meant to demonstrate you have “skin in the game”. With a traditional mortgage, a down payment of 20% is recommended but not always required. Some conventional loans allow down payments as low as 3%.

For construction loans, down payments of at least 20% are nearly universal. The reason stems from the higher risks banks take on with these types of loans

With a traditional mortgage, the home itself acts as collateral for the loan. If the borrower defaults, the bank can foreclose and sell the home to recoup losses. But construction loans fund building a home that doesn’t yet exist. Without a physical asset for security, banks consider these loans riskier.

Requiring a substantial down payment helps mitigate the chance of default. Borrowers with more cash invested are less likely to walk away if financial hardships occur. The down payment also ensures the borrower has adequate funds to complete construction if costs exceed estimates.

How Is the Down Payment Amount Determined?

While a 20% down payment is standard, the actual dollar amount depends on several factors:

• Appraised value – Most lenders base the down payment on whichever is lower between the appraised value or total construction costs.

• Construction costs – An itemized budget covering land purchase, materials, labor, fees, etc. Many lenders use this to calculate the down payment if it’s lower than appraisal.

• Loan program – Government-backed construction loans like FHA, VA, and USDA may allow lower down payments.

• Lender requirements – Some banks may require more than 20% down to mitigate risk.

Here’s a breakdown of how it works:

• A lender first determines the appraised value and construction costs.

• They take the lower of the two numbers and multiply it by 20% to get the minimum down payment.

• Additional factors like loan programs and lender policies may adjust the down payment up or down.

Let’s look at some examples to understand how this works:

Scenario 1:

• Appraised Value: $300,000
• Construction Costs: $275,000

The construction costs are lower, so the lender bases the down payment on $275,000. At 20%, the minimum down payment would be $55,000.

Scenario 2:

• Appraised Value: $325,000
• Construction Costs: $300,000

Here the appraised value is lower, so the lender bases the down payment on $325,000. At 20%, the minimum down payment is $65,000.

Scenario 3:

• Appraised Value: $350,000
• Construction Costs: $325,000
• FHA Construction Loan

While 20% of $325,000 is $65,000, an FHA loan allows a minimum down payment of just 3.5%. So for this example, the required down payment would be just $11,375.

As you can see, the specifics of your project determine the down payment amount. The only way to know for sure is to start the loan application process.

Tips for Funding Your Construction Loan Down Payment

Coming up with 20% down for a construction loan can be a stretch. Here are some tips on funding options to explore:

• Use equity from an existing home – Cash-out refinance or home equity loan/line.

• Liquidate investments – Withdraw from brokerage accounts, retirement funds.

• Set up payment plan with lender – Make down payment in installments.

• Explore down payment assistance programs – For example, USDA loans offer grants.

• Ask for gift funds – Parents, grandparents, relatives.

• Save aggressively – Make major lifestyle cuts to ramp up savings.

• Compare lender requirements – Find one that offers more flexibility.

• Get accurate estimates – A lower appraisal can reduce down payment.

• Have backup plan – Be ready to stall construction if can’t fund down payment.

The bottom line is you have options, but will likely need to make financial sacrifices. Proper planning is key to securing the down payment necessary to start building your dream home.

Frequently Asked Questions

How much down payment do I need for a $300,000 construction loan?

With a $300,000 construction loan, you can expect to need around $60,000 down. This is 20% of the amount borrowed. The exact down payment will depend on factors like appraised value and lender requirements.

What if I don’t have 20% down payment?

Without 20% down, you’ll have a hard time getting approved for a conventional construction loan. But alternatives like FHA, VA, and USDA loans allow lower down payments for those who qualify. You may also find lenders willing to accept 10-15% down if you have excellent credit and financials.

Can I finance the down payment on a construction loan?

Most lenders will not allow you to borrow the down payment on a construction loan, as it defeats the purpose of mitigating risk. If you lack sufficient cash, look into alternative funding options like home equity loans, cash-out refinancing, or down payment assistance programs.

How much down payment do I need for a $500,000 construction loan?

On a $500,000 construction loan, you can expect a down payment requirement around $100,000, or 20% of the borrowed amount. Appraisal value and lender policies could adjust this up or down slightly. Be sure to account for closing costs as well.

Can I use land as down payment on a construction loan?

Using the land itself as down payment is typically not allowed, as lenders want cash reserves. But the equity you have in land you already own can be helpful. You may be able to cash-out refinance or take a loan against the land value to come up with down payment funds.