What is a Construction Loan?

A construction loan is a financial arrangement that allows the borrower to build on a property or otherwise renovate an existing home prior to moving in. If you're cash poor and building a house from scratch, you'll likely need to borrow a significant amount of the total cost of the house construction project.

Conversely, if you need a small amount of cash to fund an improvement before getting a certificate of occupancy, it may be easier to secure a good construction loan at a sound rate.

You can also participate in what's known as construction to permanent loan financing. Basically, you pay closing costs one time on the loan, and the arrangement becomes a traditional mortgage loan when construction is completed and you acquire a certificate of occupancy. You can also get an agreement to lock in at the beginning of construction, so that, if the prime rate soars during construction, you won't be saddled with that extra rate burden.

Since you're paying construction money directly to the contractor, you may have to navigate an arrangement among you, your lender, and your contractor to create a payment schedule that works for all parties. Research the legalities, and budget for your interest-only payments before you get into business with a contractor.

The lender will often want to know your personal history, employment history, and credit score before okaying even a small interest-only construction loan. It's possible to work out a construction loan with one lender and a mortgage loan with another. However, in addition to the complications that could ensue from having two discrete lenders, you might also face additional costs, since both lenders will charge you fees for closing and paperwork processing.

If you've already purchased the actual land on which you plan to build the house, your lender may be able to hold your equity as a security against the loan and hence give you a lower interest rate. Of course, if construction project fails or other forms of financing fall through, the lender may have a claim on your property itself or at the very least on the equity built into your property.