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Traditional Mortgages vs. Construction Loans: How Do I Finance My Custom Home?

August 28, 2020

Your home may be the biggest asset you’ll own in your lifetime — which means a mortgage is probably the largest and longest-term loan you’ll ever require. However, financing the construction of a new home requires a different kind of mortgage than financing an existing home. If you’re buying a home that’s already built, you’ll need to take out a standard loan to fund such a large purchase. But when you plan to build your own home from scratch, you’ll need to take out a construction loan to cover the costs of building.

But how exactly do construction loans differ from traditional mortgages? The more you understand about how housing loans work, the easier it will be to choose which one is right for you. Keep reading as we dive into what you need to know about financing your custom home. 

When Do You Need a Construction Loan vs. a Traditional Mortgage?

When it comes to financing your home, a standard loan — also known as a home mortgage — is a loan given to you by a bank, mortgage company, or other financial institution. Your home mortgage will come with either a fixed or floating interest rate, and you’ll have anywhere from 3 to 30 years to pay it off in full. A home construction loan, on the other hand, is a short-term, higher-interest loan. It usually lasts about a year in duration, just enough time to cover the costs of building and materials for your new property. 

Here’s a rundown of how a construction loan is different from a traditional mortgage:

  • Construction loans are short term. Generally, the lifespan of a construction loan is equivalent to one year or less. In comparison, a standard mortgage loan usually lasts between 3 and 30 years. Construction of the new home should be finished by the time the construction loan term is up, and when the term of that loan ends, the amount of borrowed money must be paid back in full. If necessary, you can then either refinance the loan into a longer-term mortgage, or you can acquire a new loan in order to repay the construction loan. 
  • Construction loans come with higher interest rates. It’s important to remember that  a construction loan carries more risk than a standard mortgage. As a result, these types of loans often come with higher interest rates (usually variable) than the average mortgage. 
  • Construction loans have more strict criteria. The approval process here is different from that of a traditional mortgage. You will be asked to submit detailed blueprints of your home-to-be, as well as an estimate of construction costs and an expected timetable for the project. 
  • Construction loans require a larger down payment. Down payments for a standard mortgage can be relatively low, with some requiring as little as 3.5%. However, construction loans generally require a 20% down payment before the loan is approved, and some banks may even ask for more. Fortunately, the land on which the home is being built can usually be used as all or part of the down payment, as long as it is owned in full and isn’t currently being financed.
  • Construction loans disburse funds as needed. Unlike a standard loan, a construction loan pays out as progress is made on the home build. There are generally five phases of funding, and for each one, the borrower must submit a request. Only after a lender inspects the home and confirms progress will the funds be granted. 

In short, a construction loan is a short-term loan used to finance the construction of a home, whereas a standard loan is used for homes that have already been built. If you’d like additional guidance on this topic or would like references to our preferred lenders, don’t hesitate to contact us. We’ve helped hundreds of homeowners build their dream homes from start to finish. 

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