What Does a Construction Loan Cover?

Materials, permits, labor – building a custom home from the ground up comes with a steep price tag. While you may have secured a construction loan to help you pay for bringing your dream home to life, you may be wondering what your construction loan does – and does not – cover.

Turning a plot of land into your family home comes with a price tag of roughly $296,652, according to recent estimates provided by the National Association of Home Builders (PDF). Other industry estimates peg the cost at somewhere between $112,000 and $448,944, depending on the size of the home, its location, and the custom finishing’s you select.

That means you may be qualifying for a construction loan that’s a hefty sum. Here’s everything you need to know about your construction loan, what it will and won’t cover, and how your funds will be dispersed.

What is a Construction Loan?

Construction loans are earmarked for a specific set of future homeowners – people who have decided to build a home instead of buying one that’s already built. While most people get approved for a mortgage to purchase an existing home, construction loans provide financing to pay for the building of a property, from buying the land and materials to paying for land and building permits and the cost of labor.

What Does a Construction Loan Cover?

Essentially, you can count on your construction loan to cover every aspect of constructing your house. From the foundation, walls, and roof, here’s what your construction loan will cover.

The Cost of Land

While some people already own a plot of land, others may need to buy land to get started. 

The Foundation

The cost of excavating and laying a foundation and retaining walls at $34,850 on average.

Construction Permits

Expect to pay for building permit fees, environmental impact assessment fees, water and sewage fee inspections, and other architecture and engineering assessment fees. All in, the NAHB says permits clock in at $18,323.

Building Materials

Building a home requires everything from framing, insulation, drywall, flooring, cabinets, countertops, windows, and doors – you get the idea! Your construction loan will cover the costs your builder will incur for procuring everything your new home needs. This includes outdoor fixtures, like paving your driveway and building a deck or a front porch.

Contractor Labor

Constructing, plumbing, electrical work, HVAC systems set up, painting, roofing – your builder or various contractors will send you invoices for their hard day’s work. Your construction loan will also absorb that cost.

Major Appliances

Your refrigerator and freezer, washer and dryer, dishwasher, fireplace, even your microwave – while home furnishings are not included in your construction loan coverage, major home appliances are. That means you cannot buy a couch and coffee table set, bedroom furniture with matching nightstands, or a dining room table and expect your construction loan to cover that debt.

Closing Costs

Your construction loan will cover closing cost checkpoints, such as inspections, appraisals, loan origination fees, and title examinations.

Contingency Reserves

Your construction loan will give you a bit of wiggle room in your budget to account for unforeseen costs. Bad weather, rising prices, or delays may stall your project, but the reserves are there to cover your back financially.

Interest Reserves

Your construction loan may even provide you with the funds to cover the interest payments you’ll need to pay during the building of your home.

How Do Construction Loans Work?

Construction loans aren’t as straightforward as a mortgage. Their key features include:

They’re Short-Term

To start, construction loans provide short-term financing, usually to the tune of 12 to 18 months – they’re available as long as it takes to get your home built.

Paid in “Installments” or “Draws” Based on Construction Timeline

They’re similar to a credit card or line of credit. You’re approved for a lump sum of money that your builder can “draw” funds from for each phase of building. The amount you qualify for is based on the budget and building schedule you present to your lender during the application stage.

From there, your lender will provide financing via several advances as your builder completes each checkpoint. They’ll connect with your builder, and even send an appraiser and inspector, to monitor progress before issuing more financing to make sure the work is up to standards.

They have higher interest rates

They come with no collateral on the line, which means you’ll pay higher interest rates compared to a conventional mortgage. You’ll typically pay about one percent higher in interest on construction loans compared to a traditional mortgage.

Because you don’t have any assets on the line, construction loans are also harder to qualify for. Your lender will insist on a down payment of at least 20 to 25 percent.

They must be converted into a long-term loan or paid in full

While your home is being built, your only responsibility is to pay the interest incurred on the cash withdrawn from your construction loan account – not on the entire loan amount. But once your home is completed, the terms of your loan end and you must either pay it off entirely as a “balloon payment” or transfer it into a mortgage or other long-term financing.

Some people use the proceeds of their previous home’s sale to pay off their construction loan while others opt for a “construction-to-permanent” loan.

Do you Need to Make a Down Payment for a Construction Loan?

While lenders can seize your property if you skip out on mortgage payments, they don’t have any collateral they can turn to if you’re delinquent on your construction loan payments. Because of this caveat, your lender will insist on you making a down payment of at least 20 percent prior to approval. In short, they want you to throw some skin into the game, too.

You can provide a cash down payment, which is usually applied as the initial payment to your contractor instead of purchasing materials and other assets (which your lender can repossess in case anything goes awry).

If, however, you own the land, you may have an easier time qualifying for a construction loan by using this asset as collateral. The land itself can, at times, be worth 25 to 33 percent of the total project.

Aside from the down payment, you’ll also need to jump through other pivotal hoops to qualify for a construction loan, from having a solid credit score, to providing a detailed construction plan, budget and schedule, and showing you’ve selected a contractor who meets state licensing and insurance requirements.

Why Would you Need a Construction Loan?

Most people don’t have the cold hard cash to pay for constructing their dream home from scratch. This is precisely why they turn to construction loans. Bear in mind, the NAHB estimates that laying a foundation costs $34,850, adding framing to a home costs $5,589, and adding walls, rooves, windows and doors costs $411,690. That’s a lot of money!

Construction loans are ideal for people who:

• Own or need to buy undeveloped land with plans to construct their home property on.
• Own an aging home they want to demolish and rebuild.
• Want to build a custom home but don’t have the funds to pay for its construction.
• Want to build a custom home but won’t have the cash to pay for the costs until they sell their current residence.

Ultimately, construction loans are often the financial tool that homeowners need to build the custom home that meets their needs. They’ll cover all the bases you need to transform your dream home from blueprints into property you can move into.

They’re also flexible – you won’t have to pay for anything but the interest while the home is being built. Afterwards, homeowners can convert the loan into a longer-term mortgage, paying off the debt over the course of 25 to 30 years.