Reviewed by Aug 27, 2020| Updated on
Definition of a Construction Loan
A construction loan, also known as a self-build loan, is a short-term loan used to finance the construction of a home or other real estate project. Once long-term financing is secured, the contractor or home buyer must take out a construction loan to cover the building costs. A construction loan typically has a higher interest rate than a conventional mortgage loan, since it's considered riskier.
Construction loans are typically taken out by contractors or a homebuyer who custom-build their own home. They are short term loans, usually for one year. The borrower may either refinance the construction loan into a permanent mortgage or receive a new credit to pay off the construction loan, called the "end loan", after the construction of the house is complete.
The borrower would only be asked to pay interest on a construction loan when the project is still underway. Many construction loans can require payment of the balance in full by the time the project is complete.
Special Considerations for Construction Loans
Many lenders demand a minimum 20% down payment on a construction loan, and some allow up to 25%. Borrowers can face difficulty securing a building loan, particularly if they have a limited credit history.
There could be a lack of collateral as the home is not yet constructed, which poses a challenge in obtaining a lender's approval. The borrower would need to provide the lender with a detailed list of design information (also known as a "Blue Book") to obtain approval for a building loan. The creditor would also have to show that the project includes a professional contractor.
Local credit unions or national banks provide construction loans. Local banks may be familiar with their area's housing market and make home-building loans more convenient for borrowers within their locality.