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Buying your dream house requires a mortgage, but building your dream house? Well, that requires a mortgage with a twist.

Construction loans are shorter term, higher interest rate loans that cover the cost of building or rehabilitating a house. The lender pays a construction loan to the contractor — not the borrower — in installments as building milestones are achieved. Once building is complete, home construction loans are either converted to permanent mortgages or paid in full.

Building is your chance to have everything you want in a home, but the construction loan process can be complicated. Learn how the different types work and how to choose a lender before breaking ground.

» MORE: 4 reasons to buy new construction

Construction loan types

What does a construction loan cover?

Every project is different, but in general, a construction loan pays for:

• Land
• Plans, permits and fees
• Labor and materials
• Closing costs
• Contingency reserves (in case the project costs more than estimated)
• Interest reserves (if you don’t want to make interest payments during building)

How does a construction loan work for a new home?

When you borrow money to build a house, there’s no collateral to back up the loan the way there is in a traditional mortgage — at least not yet. This makes lenders nervous, so you have to jump through some additional hoops before they’ll fork over the cash. Expect a thorough inspection of the architectural plans and your builder, as well as your finances.

Expect a thorough inspection of the architectural plans and your builder as well as your finances.

Disbursement of a construction loan also works differently than with a traditional loan. Instead of transferring a lump sum, lenders pay home construction loans to the builder in installments, called “draws.” Each draw coincides with an important phase of the project, such as pouring the foundation, framing and finishing work.

“An inspection is required before each draw disbursement to the builder,” said Chris Nard, president of mortgage at Citizens Bank, via email. “The amount of the disbursement is based on the work completed, as specified in the inspection report.”

» MORE: See how much house you can afford

How does a construction loan work for a remodel?

If your dream house needs a lot of TLC, a renovation construction loan lets you wrap upgrade and repair costs into your permanent mortgage, says Sean Faries, CEO of Land Gorilla, a software company for construction lenders based in San Luis Obispo, California.

You can find renovation loans through programs including Fannie Mae’s HomeStyle Renovation Mortgage, Freddie Mac’s Renovation Mortgage, the FHA’s 203k loan and the USDA’s Single Family Housing Guaranteed Loan Program.

Like a typical construction loan, the amount you can borrow for a renovation depends on an appraiser’s estimate of value once repairs and upgrades are complete. The lender still needs to approve your contractor and renovation plans, and it still pays the money in installments.

The benefit of financing big renovations with a construction loan, rather than a personal loan or a home equity line of credit, is that you’ll generally pay a lower interest rate and have a longer repayment period.

» MORE: Buying a historic home? Read this first

Prepare for the builder review

A mortgage is usually a transaction between a lender and a borrower, but construction loans add a third party to the mix: the builder. Everything hinges on your contractor’s ability to complete the construction plans on time and within budget, so hire carefully.

“Check the builder’s references and look at other work they’ve completed. Make sure their plans and specifications are approved by the local building authority and they’re ready to move forward on the project,” Faries says.

A lender may request your builder’s work history and proof of insurance, blueprints, specifications, a materials list, a detailed budget and a signed construction contract that includes start and finish dates.

» MORE: DIY or hire a pro?

How to choose a construction loan lender

Remember that not every mortgage lender offers a construction product, says Ray Rodriguez, TD Bank’s regional mortgage sales manager for New York. When you find a few lenders that do, compare their rates and terms. He also recommends getting prequalified before you even think about blueprints.

Get prequalified before you even think about blueprints.

“The last thing you want to do is spend a lot of money on plans and specs, only to find out you can’t get a loan because of your credit score,” Rodriguez says.

Credit underwriting for a construction loan is generally the same as for a traditional mortgage, according to Rodriguez, though “it may take a little longer to close because you have multiple parties involved and you’re underwriting subjectively based on future value.”

How to qualify for a construction loan

As with traditional mortgages, “minimum credit scores, maximum debt-to-income ratios and down payment requirements vary from lender to lender, and are usually based on the amount of money borrowed,” Nard says.

Lenders will review your:

• Debt-to-income ratio: Lenders generally expect your debts to total no more than 45% of your income, and lower is better
• Credit score: Most construction loan lenders require a credit score of 680 or higher
• Down payment: A 20% to 30% down payment is typically required for new construction, but some renovation loan programs may allow less
• Repayment plan: With a construction-only loan, the lender might want to know if you’ll pay the balance in cash or refinance when building is complete

Remember, building a home takes a long time and the process has lot of moving parts, so you must select your financing with care. “Some lenders do an outstanding job of managing borrower and builder expectations,” Faries says. He recommends looking for an experienced construction lender who can lead you through the process with minimal frustration.

By Beth Buczynski

NerdWallet

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