How Home Construction Loans Work

If you’ve decided to build your home rather than buy an existing one, you’ll need to obtain a construction loan. A home construction loan covers the costs of building your home. Some construction loans have higher interest rates and a shorter term than a traditional mortgage. Others can be transitioned into mortgages once construction is complete. If you intend to purchase an old home at a discount and renovate it or do significant renovations to a home you already own, you may also be able to obtain a home improvement loan to do so.

The Best Home Construction Lenders of 2020

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    Home construction loans versus standard home loans

    Unlike a traditional home loan, construction loans are paid out in installments rather than a lump sum. Rather than being paid to you, each installment is paid directly to the builder as each phase of the building process is completed.

    For this reason, it’s important to work with a reputable builder and plan out each phase of your construction project before applying for a home construction loan. You should also have a clear estimate of how much it will cost to build your house. Once construction is complete, the cost of the loan will be transferred to you and you will be responsible for repayment per the loan’s conditions.

    It’s important to note that, as a consumer, taking out a construction loan generally involves taking on a higher level of risk than you would with most traditional mortgages.

    According to John Donlon, co-founder of GoldCoast Mortgage in Beverly, Massachusetts, “There are a lot of moving parts when it comes to building a house with a new construction loan, and there are categories of risk that the consumer may not even be aware of and are outside of their control.” These include risk categories like the weather, but also risks associated with the team working on the project.

    For this reason, home construction loans are typically best handled by a business owner, such as the builder. “For the homeowner, it’s best to transfer that risk to the builder, as they can assess the risk of contractors, sub-contractors, on-site health risks to workers, and other factors,” says Donlon. “In most cases, we recommend the consumer make a contract to buy a finished project from the builder and allow the builder to manage the financing. This keeps the builder motivated to deliver a great product and it removes those categories of risk that the consumer just can’t be expected to handle.”

    Different types of home construction loans

    There are three different types of home construction loans. The one you choose will depend on the goals you have for your new home and your financial situation. The most common types of home construction loans are construction-to-permanent loans and stand-alone construction loans.

    Construction-to-permanent (C2P) loans

    A C2P loan converts to a permanent mortgage once construction on your home is completed. Your interest rate will be locked in when the loan is closed.

    This is the best choice if you have a construction plan in place, if you intend to live in your home once it’s built or if you don’t otherwise intend to sell it. Once construction is complete, you’ll have a predictable interest rate on your mortgage.

    Stand-alone construction loans

    Unlike a C2P loan, a stand-alone construction loan must be paid off once construction is complete. The loan does not convert into a mortgage.

    This type of loan is only a good idea if you have large cash reserves. Some homebuyers also opt for this type of loan if they believe the proceeds from the sale of their previous home will cover much of the cost of the new one.

    Renovation construction loans

    Renovation construction loans typically finance substantial renovations to an existing property, such as adding additional rooms or levels. Depending on the loan you obtain, you may not be required to make payments if you can’t live in your home while it is being renovated.

    Like new home construction loans, renovations loans also carry a certain amount of risk due to factors outside the consumer’s control. There are also risks involved with taking out FHA 203k loans.

    “When you take out an FHA 203k, you end up stuck with a minimum of eleven years of mortgage insurance that never decreases. You can also get into pitfalls with home equity lines of credit, which often carry a maximum adjustable interest rate of 19.99%. For home renovations, we recommend our clients use other options that don’t involve risking their homes, such as borrowing from their own retirement accounts or other non-secured options,” explains Donlon.

    Best home construction loan lenders

    BB&T Bank

    BB&T Bank is based in Winston-Salem, North Carolina, and operates over 2,000 band branches in multiple states. The bank’s home construction loans are a good choice if you’re looking for a C2P loan, as you’ll only have to pay interest during the construction period.

    You can apply for either a fixed or an adjustable-rate loan and there are no prepayment penalties. BB&T home construction loans only require one closing and a single set of closing costs.

    Citizens Bank

    Headquartered in Providence, Rhode Island, Citizens Bank operates in surrounding New England states as well as others, such as Ohio and South Carolina. Citizens Bank lets you start the home construction loan process online, but they offer one-on-one support with a loan officer throughout the process.

    Citizen Bank lets you verify information using a secure document exchange, which can help you qualify faster. Most of the bank’s home construction loans are made for a duration of one year or less.

    Wells Fargo

    Wells Fargo is a large financial bank that offers several loan products, including mortgages and home construction loans. The bank provides prospective home buyers with a range of useful tools, such as their “new construction home financing checklist” and instructional videos.

    When you obtain a home construction loan with Wells Fargo, you can take advantage of their Builder Best Extended Rate Lock program, which protects your interest rate while your home is being built. For a fee, you can lock down a range of interest rates for 6 to 24 months on different types of loans. This makes Wells Fargo a decent choice for C2P loans.

    US Bank

    US Bank is a consumer and personal banking company owned by Berkshire Hathaway. The bank offers traditional banking services to consumers, including savings and checking accounts, credit cards and loans.

    US Bank offers a range of home construction loans like other banks, including construction-to-permanent loan options. However, their biggest selling point is their online platform, which includes tools to match you with a local loan officer.

    TD Bank

    TD Bank is a national bank that provides loans, banking services and credit cards to consumers primarily on the eastern coast. Their home construction loans come with either a fixed or adjustable-rate and include interest-only payments during the construction phase. You can also lock down your interest rate at the start of construction.

    You can begin TD Bank’s home construction loan process online, by phone or in person at a TD Bank branch.

    Bank of America

    Bank of America is one of the largest banks in the world, providing banking and financial services to both businesses and consumers. In addition to its range of mortgage products, Bank of America also offers construction loans through its National Builder Division. This is a program that builders can take part in so their customers can access specialized construction loan products.

    Bank of America home construction loans come with the Builder Rate Lock Advantage, which lets builders lock down interest rates for both fixed and adjustable-rate loans for up to 12 months. The bank finances home construction projects up to $5 million.

    Best Home Construction Loans Summed Up

    LenderLock-In Rate TermAPR*Min. Down Payment
    BB&T BankUp to 12 months3.364% – 3.830%3%
    Citizens BankUp to 12 months3.125% – 3.625%3.5%
    Wells Fargo6 – 24 months3.240% – 3.872%3%
    US BankN/A3.625% – 3.946%3%
    TD BankUp to 12 months3.843% – 4.687%3%
    Bank of AmericaUp to 12 months3.291% – 3.837%3%

    *Based on advertised rates as of 12/10/2019

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    Michael Rand

    Contributing Writer

    Michael Rand is a business and personal finance writer based in Beverly, Massachusetts. He holds a master’s degree in writing from Salem State University and spent years producing content for financial services clients as an agency writer. His work has been featured in publications like Interest.com, The Simple Dollar, and Monetize.info.