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If you’re looking to buy or build a home, you’ll likely need to take out some type of loan. Two common options are mortgage loans and construction loans. While they share some similarities, there are important differences between these two types of home loans that you should understand before applying for financing.
In this article, I’ll explain what mortgage loans and construction loans are, how they work, and the key differences between them. I’ll also provide tips on deciding which type of loan is right for your home buying or building needs.
What is a Mortgage Loan?
A mortgage loan is a type of loan used by buyers to purchase existing residential properties like single-family homes, townhomes, or condos.
With a mortgage loan, the property itself serves as collateral for the loan. This means if you default on the loan, the lender can foreclose and seize the home.
Mortgages come in a few main varieties
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Conventional loans – Issued by private lenders like banks. Typically require a down payment of at least 3-20%.
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FHA loans – Insured by the Federal Housing Administration. Down payments as low as 3.5%.
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VA loans – For veterans and military members. No down payment required.
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USDA loans – For rural borrowers. No down payment required
Most mortgages have fixed interest rates and 15 or 30 year loan terms. You make one payment each month covering principal and interest.
Mortgage loans are a great option if you want to purchase an existing home. But what if you want to build a new home from the ground up? That’s where construction loans come in.
What is a Construction Loan?
A construction loan is a short-term loan used to finance the building of a new residential property. The funds can cover buying land, materials, labor, permitting fees, and other construction costs.
With a construction loan:
- The interest rate is usually variable, moving up and down with market rates
- The loan term is shorter – generally 1 year or less
- The lender disburses funds in stages as construction milestones are met
- You only make interest payments during the construction period
Once construction is finished, there are two options:
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Construction-only loan – You pay back the full loan amount at maturity, either in cash or by getting a mortgage.
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Construction-to-permanent loan – The construction loan converts to a fixed-rate mortgage for the long term.
Construction loans allow you to build and customize your dream home. But they work differently than standard mortgages.
Key Differences Between Mortgage Loans and Construction Loans
Now that you understand the basics of mortgage loans and construction loans, let’s take a closer look at some of the key differences between them:
Collateral and Risk
With a mortgage, the home being purchased acts as collateral securing the loan. This gives lenders lower risk.
Construction loans are riskier for lenders because there’s no existing asset backing the loan during the building phase. The lender’s only recourse if you default is to take ownership of the unfinished home.
Loan Term
The standard mortgage term is 15-30 years. Construction loans generally have much shorter terms of around 1 year or less.
Interest Rates
Mortgage rates are fixed, while construction loan rates fluctuate. The construction loan rate is often 1% or more higher than prevailing mortgage rates.
Payment Structure
With a mortgage, you immediately start making payments covering principal and interest. Construction loan payments often cover only the interest until construction is complete.
Funds Disbursement
Mortgage funds are dispersed upfront in a lump sum at closing. Construction loans are paid out incrementally as certain milestones are reached during the building phase.
Fees and Closing Costs
A construction-only loan requires two sets of closing costs – one for the construction loan and another for the permanent mortgage. With a construction-to-permanent loan, you only pay closing costs once because it converts to a mortgage.
Qualifying Criteria
Construction loans tend to have tougher credit score and down payment requirements compared to some mortgages, like FHA and VA loans. Construction lenders also review plans, budgets, and other details about the project.
Tips for Deciding Between a Mortgage and Construction Loan
Here are some tips to help you choose between getting a mortgage or construction loan:
- If buying an existing house, a mortgage is likely your only option
- Construction loans allow you to fully customize your home and its layout
- Construction loans tend to have higher rates and stricter approval criteria
- Construction loans require managing the building process and interacting with contractors
- Construction-to-permanent loans can save on long-term fees compared to construction-only
- Consider both purchase price and total borrowing costs when running numbers
- Think about your timeline, how soon you need the home, and current interest rates
- Be realistic about your budget and how much house you can truly afford
The choice depends on your specific situation, needs, and financial capabilities. Speak to qualified lending professionals to go over different scenarios and make sure you understand all the costs involved before moving forward.
With the right information, you can determine whether a traditional mortgage or construction loan better fits your home ownership goals. Just be sure to weigh the pros and cons carefully as you make this important financial decision.
Construction loans vs. traditional mortgages
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. These draws tend to happen when major milestones are completed — for example, when the foundation is laid, or the framing of the house begins.
- The repayments: With a mortgage, you start paying back the principal and interest right away. With construction loans, your lender will typically expect you to make interest payments only during the construction stage. Additionally, borrowers are typically only obligated to repay interest on any funds drawn to date until construction is completed.
- Inspection/appraiser involvement: While the home is being built, the lender has an appraiser or inspector check the house during the various construction stages. As the work is approved, the lender makes additional payments to the contractor, known as draws. Expect to have between four and six inspections to monitor the progress.
- Requirements: Construction loan requirements include being financially stable and having the ability to make a down payment. Lenders also want to see a construction plan, which you can read more about below.
- Interest rates: Construction loan interest rates are typically higher than traditional mortgage rates. This is often because you’re not providing collateral to back the loan, which means the lender is taking on more risk.
What are construction loans?
Construction loans are loans that fund the building of a residential home (aka a stick-built house), from the land purchase to the finished structure. Common types are a standalone construction loan — a short-term loan (generally with a year-long term) — which only finances the building phase, and a construction-to-permanent loan, which converts into a mortgage once the construction is done. Borrowers who take out a standalone construction loan often get a separate mortgage to pay it off when the principal falls due.
You can use a construction loan to cover such costs as:
- The land
- Contractor labor
- Building materials
- Permits
The differences between Construction Loans and Long Term Mortgages
FAQ
What’s the difference between a construction loan and a mortgage?
Is it easier to get a loan to build or buy?
What is the minimum FICO score for a construction loan?
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.
What is a construction loan?
A construction loan is a short-term loan that covers only the costs of custom home building. This is different from a mortgage, and it’s considered specialty financing. Once the home is built, the prospective occupant must apply for a mortgage to pay for the completed home.
What is a construction mortgage?
A construction mortgage is a loan that pays for building a new home. During construction, most loans of this type are interest-only and will disburse money incrementally to the borrower as the building progresses. The two most popular types of construction mortgages are stand-alone construction and construction-to-permanent mortgages.
Should you get a construction loan or a mortgage?
If you’re building a home, a construction loan makes the most sense. While the term is shorter, you can choose to convert it into a mortgage if you can’t pay the entire loan after your builder completes the project. That way, you can comfortably afford the home of your dream home.