Everything You Need to Know About Interest Only Construction Loans

Getting an interest only construction loan can be a great option for financing the building of your dream home. With this type of loan, you only pay the interest during the construction phase, allowing you to conserve cash flow for the project. Once construction is complete, the loan converts to a traditional fully amortized mortgage.

I want to provide you with a comprehensive guide to interest only construction loans. By the end you’ll understand what they are their pros and cons, eligibility requirements, how to get one, and more. Let’s dive in!

What is an Interest Only Construction Loan?

An interest only construction loan is a short-term financing option to fund the building of a new home. As the name suggests, you only pay the interest on the loan during the construction period. This helps free up cash flow compared to a traditional construction loan where you pay interest plus principal each month.

Here’s a high-level overview of how an interest only construction loan works

• You take out the construction loan before building starts. The loan amount covers the cost to build the home.

• You pay interest-only payments during the construction phase, which typically lasts 6-12 months. You don’t pay down any principal during this period.

• Once construction is finished, the loan converts to a traditional fully amortized mortgage. At this point your monthly payments go towards both interest and principal.

• The mortgage has a set repayment term like a 15 or 30-year loan. By the end of the term, the loan is fully paid off.

The interest only period helps reduce your monthly payments during construction when expenses are highest. You can conserve more cash flow for construction costs.

Pros and Cons of Interest Only Construction Loans

Interest only construction loans have unique advantages but also some drawbacks to consider:

Pros

• Lower monthly payments during construction – Only paying interest frees up cash flow for build costs

• Short term structure – The interest-only period is 6-12 months until permanent financing kicks in

• Get into your new home faster – Conserve costs with lower payments during construction

• Tax deductions – The interest paid during construction is tax deductible

Cons

• Higher interest rates – Lenders view these as higher risk so interest rates tend to be higher

• Requires lump sum payment later – You still have to pay down the full principal eventually

• Not paying down principal – You don’t build equity during the interest only period

• Need to qualify twice – You have to qualify for both the construction loan and permanent mortgage

As you can see, the pros of an interest only construction loan mostly relate to conserving cash flow during the build. But you trade off higher rates and the need to pay off the full principal down the road.

Interest Only Construction Loan Requirements

Here are some typical eligibility requirements for interest only construction loans:

• Credit score – Most lenders require a minimum score between 680 and 720

• Down payment – Expect a 20-25% down payment requirement

• Debt-to-income ratio – Your DTI will need to be below 43% in most cases

• Loan-to-value ratio – LTVs up to 80% are typical

• Cash reserves – Having 12-18 months of mortgage payments in cash reserves is common

Requirements can vary by lender. The stronger your finances, the better chance you have of qualifying. High credit scores, low debt, and ample cash reserves are key.

You’ll also need to have construction plans, a general contractor, and usually multiple inspections during the build. The lender will want to confirm the home is being built on time and according to plan.

How Do You Get an Interest Only Construction Loan?

The process of getting an interest only construction loan involves a few key steps:

1. Find a lender

Many banks and mortgage lenders offer construction loans. Work with a lender familiar with these specialized loans. Ask about their experience, rates, fees, and requirements.

2. Submit loan application and documents

You’ll need to provide documentation that shows you meet the lender’s eligibility criteria. This includes pay stubs, tax returns, bank statements, and details on the construction project.

3. Get appraisal and approve plans

The lender will order an appraisal of the property and review your construction plans. Both need to be approved before they will issue the loan.

4. Close on the construction loan

At closing, you’ll sign the loan documents and the funds will be available to start construction. You’ll make interest only payments during this phase.

5. Convert to permanent financing

Once construction is done, the loan converts to a traditional mortgage. You’ll now pay down principal and interest each month.

It’s critical to find an experienced construction lender. You want a knowledgeable loan officer who can guide you through the multiple steps involved.

What Are Current Interest Rates on These Loans?

Interest rates on construction loans tend to run higher than rates for traditional mortgages. This is because lenders view construction lending as higher risk overall.

In today’s rising rate environment, interest only construction loan rates are in the range of 7-9% for well qualified borrowers. Rates run even higher for less qualified applicants.

Compare rates across multiple lender to find the most competitive interest rate. Ask if they offer discounts for existing customers or other ways to lower the rate.

Keep in mind the rate during the construction phase may differ from the rate on the permanent mortgage once the project is finished.

Mistakes to Avoid When Getting This Type of Loan

When going through the construction loan process, be sure to avoid these common mistakes:

• Not budgeting for cost overruns – Projects often run over budget so have contingency funds ready.

• Skipping inspections – Don’t authorize payouts without proper inspections first.

• Ignoring loan requirements – Follow all rules to avoid delays in funding or project completion.

• Not locking in permanent financing – Have this loan finalized before you even start building.

• Not comparing lender options – Check rates and terms with multiple lenders first.

• Making changes mid-project – Alterations require approval and can hold up the process.

• Poor communication – Always keep your lender informed of progress to avoid problems.

Having a solid understanding of the construction lending process and communicating regularly with your lender will help your project go smoothly from start to finish.

Alternatives to Interest Only Construction Loans

If an interest only construction loan doesn’t fit your needs, here are a few alternatives to consider:

• Traditional construction loan – You pay interest plus principal each month during the build phase

• Home equity line of credit (HELOC) – Use funds from an existing home’s equity to finance the new build

• Personal loan – An unsecured personal loan with fixed payments over a set repayment term

• 401(k) or IRA loan – Use retirement savings temporarily and repay yourself over time

• Portfolio loan – A loan financed by a bank or credit union instead of being sold to investors

Each option has pros and cons. Work with a loan officer to determine the most fitting construction financing for your situation.

The Bottom Line

While applying for and managing an interest only construction loan requires some extra work, it can be an effective way to build your dream home while conserving cash flow during the building phase.

Just be sure to find an experienced lender, understand requirements, budget carefully, and communicate regularly throughout the project. Used strategically, an interest only construction loan can be a win-win way to turn the home you’ve always wanted into reality!