Many people dream of not only owning their own home, but owning the home of their dreams. Unfortunately, many believe that once they enter “dream home” territory, they’ve entered a realm they simply can’t afford.
Their first instinct might be to look into mortgage loans, but those are meant for buying an existing home. Instead, construction loans offer a borrower-friendly financing option for building a brand-new house—the very same “dream home” we mentioned earlier.
In this blog, we’re taking a look at how construction loans work—including how monthly payment amounts are calculated. This way, you’ll have a better idea of what your construction loan payment schedule might ultimately look like, allowing you to make the best financing decision possible.
Construction loans provide financing to build a brand new home from the ground up. Unlike traditional mortgages used to purchase an existing house, construction loans offer short-term financing to cover the costs of buying land and materials as well as paying for labor during the building process.
One key difference between construction loans and mortgages is the interest rate. Construction loans typically have higher interest rates than mortgages. Below we’ll explore why and provide tips for getting the best construction loan rate
What is a Construction Loan?
A construction loan is a short-term loan, usually 12-18 months, that provides financing to build a new home The funds can be used to
- Purchase land to build on
- Pay for building materials
- Cover labor costs
- Pay for permits and fees
- Access contingency funds in case the project goes over budget
With a construction loan, the full loan amount is not given upfront. Instead, funds are dispersed in installments as each stage of construction is completed. This is known as “draws.” Before each draw, a lender inspector verifies the completion of that construction phase.
Once the new home is finished, the construction loan must either be paid off in full or refinanced into a traditional mortgage. Many lenders offer construction-to-permanent loans that convert to a mortgage automatically upon completion.
Why Do Construction Loans Have Higher Interest Rates?
The average interest rate for a construction loan falls between 5-10% APR. This is about 1-2 percentage points higher than current mortgage rates.
There are a few key reasons construction loan rates tend to be higher:
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Higher Risk – Construction loans are riskier for lenders than mortgages on completed homes. With a mortgage, if the borrower defaults, the lender can foreclose on the home. But construction loans aren’t backed by an existing asset.
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Shorter Term – Construction loans are designed as short-term financing. The terms are usually 12-18 months. Shorter loan terms tend to have higher interest rates.
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Variable Rates – Most construction loans have variable rates tied to an index like the Prime rate. Variable rate loans tend to have higher starting rates than fixed rate mortgages.
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No Habitable Collateral – Construction loans aren’t secured by a livable home like a mortgage is. The collateral is usually just the land value until the home is built. This increases the lender’s risk.
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Specialized Lenders – Since construction lending is complex, fewer lenders offer these products. Less competition can lead to higher rates.
Tips for Getting the Best Construction Loan Rate
Though construction loan rates run higher than mortgages, you can still get the lowest rate possible by following these tips:
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Shop Around – Compare offers from several lenders. Even a small rate difference can save thousands over the loan term.
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Improve Your Credit – Most lenders require a minimum 680 credit score. But borrowers with scores of 720+ tend to get lower rates.
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Put 20% Down – Making a down payment of at least 20% of the project costs results in better rate offers.
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Shorten the Term – Opt for a 12 month construction loan term rather than 18 months if possible. Shorter terms may have lower rates.
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Pay Interest Upfront – Paying all interest costs for the construction phase upfront can result in a lower rate.
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Use a Broker – An experienced broker can shop your deal to multiple lenders and negotiate the best rate.
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Lower the Risk – A detailed construction plan and timeline, plus a qualified licensed builder, can give lenders confidence to offer better rates.
What Affects Construction Loan Rates?
Many factors determine the specific interest rate a lender will offer on a construction loan. These include:
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Credit score – Borrowers with higher scores get lower rates
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Down payment – 20% down or more results in the best rates
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Loan-to-value (LTV) – How much you borrow versus the land value affects rates
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Loan term – Shorter 12 month terms get better rates than 18 months
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Variable vs fixed – Fixed rate loans have higher rates than variable ones
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Loan size – Higher loan amounts may have slightly elevated rates
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Construction timeline – A detailed timeline lowers risk and earns better rates
In today’s rising rate environment, construction loan rates are also gradually increasing. But shopping around and strengthening your financial profile can help you get the lowest rate.
Construction Loan Rate vs Mortgage Rate
One of the biggest factors determining what interest rate you’ll pay is whether you get a construction loan or traditional mortgage.
Here’s how construction loan rates compare to current mortgage rates:
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30-year fixed mortgage rates: 4.5-6%
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15-year fixed mortgage rates: 3.5-5%
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5/1 ARM mortgage rates: 3-4%
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Construction loan rates: 5-10%
As you can see, construction loans rates can run 1-2 percentage points higher than mortgage rates. But this gap is well worth it for the chance to build a customized home exactly to your specifications.
An experienced loan officer can check your eligibility for both construction financing and a mortgage. They can help you understand how your personal finance profile and the specifics of your project will affect your rate options for each.
Alternatives to a Construction Loan
Some homeowners looking to build opt for alternatives to a construction loan to finance their projects. Here are a few options:
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Home Equity Loan – These tap your existing home equity at a fixed rate. Only for current homeowners.
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Home Equity Line of Credit (HELOC) – A revolving credit line secured by home equity. You only pay interest on what you use.
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401k/IRA Loans – You can borrow against your own retirement savings and pay yourself back over 5 years.
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Personal Loans – Unsecured loans that don’t require collateral. Shorter terms have lower rates.
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Partner Financing – Some builders partner with lenders to offer financing as part of their construction package deals.
Each option has pros and cons. A financial advisor can help analyze the most cost-effective way to fund your build.
Lock In Your Rate Before Construction Begins
With a construction loan, you’ll want to lock in your interest rate before breaking ground. Rate locks hold your rate for 30-90 days. This prevents it from rising before you draw on the funds.
Ask your lender if they charge a fee to lock the rate. Many lenders offer free float-down locks. These let you snag a lower rate if they drop during your lock period.
A trusted construction loan officer will guide you through getting the lowest rate on your build loan. They can advise the best time to lock based on current market trends.
The Bottom Line
Construction loans carry higher interest rates than traditional mortgages to account for their shorter terms, variable rates, and higher risk. But for a chance to build your dream home from the ground up, the extra rate is worth it to many homeowners.
Following the tips above can help you get the most favorable rate possible. And shopping around to multiple lenders prevents you from overpaying. With current rates around 5-10% APR, move forward confidently financing your new construction project.
What Is the Expected or Required Down Payment for a Construction Loan?
Common sense would indicate that a larger down payment should reduce your monthly loan payments, and that is generally true. That doesn’t mean it’s worth over-extending yourself to make a larger down payment than you can really afford or budget for, however.
Usually, you should consider a few factors when zeroing in on the right down payment amount:
- The total projected construction cost, which is usually determined by the builder.
- The total construction loan amount, which you’ll work with the lender to determine.
- The future home’s appraised value, which an independent, third-party appraiser is responsible for assessing.
With a construction loan, the lender typically agrees to loan a certain percentage (95%, for example) of the future home’s appraised value. Then, they’ll suggest a down payment equal to the difference between the approved loan amount and the construction costs.
- For example, if your future appraised value is $300,000 you might be approved for a loan worth $285,000. Then, to calculate an appropriate down payment, you would subtract that loan amount from the projected construction costs. So, if construction is expected to cost $325,000, you would be looking at a down payment of $40,000.
What Kind of Loan Is Best for Construction?
In simple terms, a construction loan is specifically intended to finance the building of a new home (rather than financing the purchase of a new home), making it the right option for new construction.
Construction Loans: What They Are and How They Work (IN DETAIL)
FAQ
How do you calculate interest on a construction loan?
Who pays interest during construction?
Why are construction loan rates higher?
Is a construction loan a good idea?
Do you have to pay interest on a construction loan?
Draws are scheduled based on the construction timeline, and your lender likely will send an inspector to evaluate the status of construction prior to each payment. In most cases, you’ll only need to repay interest on funds as they are drawn—not on the entire loan amount.
What is the average interest rate on a construction loan?
The average interest rate on a construction loan is **variable** and typically **ranges between 5% and 6%** .However, interest rates for construction loans can fluctuate and may be subject to change .
Why do construction loans have a high interest rate?
Construction loans are short-term loans that are usually issued for up to 12 months. They have a high interest rate because these loans are not backed by collateral and are considered risky. In addition to that, construction loans tend to have an adjustable interest rate, which means that the interest rates may change as the prime rate changes.
What is the difference between a construction loan and a mortgage?
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.