Types of construction loans

Construction-to-permanent loan 

Construction-to-permanent loans provide the funds to build the dwelling and for your permanent mortgage as well.

In other words, with a construction-to-permanent loan, you borrow money to pay for the cost of building your home, and once the house is complete and you move in, the loan is converted to a permanent mortgage.

The benefit of this approach is that you have only one set of closing costs to pay, reducing your overall fees.

Once it becomes a permanent mortgage — typically with a loan term of 15 to 30 years — then you make payments that cover both interest and the principal. At that time, you can opt for a fixed-rate or adjustable-rate mortgage.

Construction-only loan

A construction-only loan provides the funds necessary to complete the building of the property, but the borrower is responsible for either paying the loan in full at maturity (typically one year or less) or obtaining a mortgage to secure permanent financing.

The funds from these construction loans are disbursed based upon the percentage of the project completed, and the borrower is only responsible for interest payments on the money drawn.

Construction loan rates are almost always tied to the prime rate plus a margin. Additionally, they might have a higher rate than traditional mortgages. Construction-only loans can ultimately be costlier if you will need a permanent mortgage because you complete two separate transactions and pay two sets of fees.

Another consideration is that your financial situation might worsen during the construction process. If you lose your job or face some other hardship, you might not be able to qualify for a mortgage later on — and might not be able to move into your new house.

Renovation loan 

If you want to upgrade an existing home rather than build one, you can look for a renovation loan, which comes in a variety of forms depending on the amount of money you’re spending on the project.

If a homeowner is looking to spend less than $20,000, they could consider getting a personal loan or using a credit card to finance the renovation. For renovations starting at $25,000 or so, a home equity loan or line of credit may be appropriate, if the homeowner has built up equity in their home. HELOCs are typically the most affordable way to borrow a large sum of money because of their low interest rates.

Another strong option in the current low mortgage rate environment is a cash-out refinance, whereby a homeowner would take out a new mortgage at a higher amount than their current loan and receive that overage in a lump sum. This is another effective, affordable way to tap your home’s equity to improve your property.

With any of these options, the lender generally does not require disclosure of how the homeowner will use the funds. The homeowner manages the budget, the plan and the payments. 

Meanwhile, using a construction loan to finance a renovation is a more thorough process. Unlike with other forms of financing, the lender will evaluate the builder, review the budget and oversee the draw schedule, and overall manage the process. 

Owner-builder construction loan

Owner-builder loans are construction or construction-only loans where the borrower also acts in the capacity of the home builder.

Most lenders won’t allow the borrower to act as their own builder because of the complexity of constructing a home and experience required to comply with building codes. Lenders that do typically only allow it if the borrower is a licensed builder by trade.

End loan

An end loan simply refers to the homeowner’s mortgage once the property is built. A construction loan is used during the building phase and is repaid once the construction is completed. A borrower will then have their regular mortgage to pay off, also known as the end loan.