How Does a Construction Loan Work? Is It Difficult To Get One? Experts Break It Down

by HMLS

Capital-intensive projects like construction require a quick and seamless flow of funds to ensure efficient completion. You may have perfected the 3D design plans or lined contractors up, but nothing can be set in motion until your construction loan is in order.

Construction loans are not like your traditional home mortgages. Right from the screening process and qualification paperwork to the fund release pattern, you’re up for a different experience. As a borrower, it’s crucial to have accurate logistical info and awareness of your available options—we’re here to help you with that.

Our guide is set up by industry experts and has answers to all the questions you may have, including:

  • How are construction loans structured?
  • Can you roll a construction loan into a mortgage?
  • What are the requirements for a construction loan?
  • Who are the best lenders for construction loans?

What To Know About Construction Loans—Meaning and Basic Structure

A construction loan is a mortgage product designed to help a borrower finance the building of a residential or commercial property on a piece of land. It can be used for ground-up projects, major extensions and additions, and remodeling or reconstruction plans. Construction loans are typically not used for property rehabilitation and home renovation—rehab loans work better in these scenarios.

What Is the Structure of a Construction Loan?

The structure of a construction loan is nowhere near what a regular, long-term home mortgage looks like. When a borrower takes out a mortgage to purchase a new home, the logistics are straightforward—the underlying asset serves as the collateral, which can reimburse the lender if the borrower defaults. Based on this security, home loans have low interest rates and long repayment or amortization schedules.

A construction loan is a bit of a gamble from the lender’s perspective because there is no readymade “home” to back it up. Say a borrower exhausts the construction loan halfway through the project, and there’s still no livable structure in sight—that’s practically money down the drain for the lender because they have limited avenues to recover the investment. Due to the higher risk involved, construction loans have stricter terms (higher interest rate and shorter tenure) than traditional mortgages.

Source: Jens Behrmann

Refer to the following table to understand the primary structural components of a typical construction loan:

ComponentConstruction Loan
Interest rate6%–18% (fixed or fluctuating), depending on the borrower’s creditworthiness
TenureShort-term, usually 1–3 years
Fund disbursalIn stages—traditional lenders (like banks) examine the budgeted construction plan and prepare a draw schedule to determine what amount to release during each draw, depending on the progress of the project. The stage-limited funding prevents the borrower from overspending
RepaymentInterest-only payments with a balloon repayment at the end of the term (unlike home mortgages, which have an amortized repayment schedule)

What Does a Construction Loan Cover?

The range of expenses covered by a construction loan depends on the type of product you choose and the individual lending terms of the financier. Most lenders provide funds for the following:

  • Cost of land
  • Contractor or labor expenses
  • Raw materials
  • Plans, permits, and fees
  • Contingency reserves (for covering unexpected costs and inflation-based price jumps)
  • Closing costs
  • Interest reserves (for the temporary payment of interest, usually offered to commercial borrowers who won’t earn a profit on the project right away)

Keep in mind that a construction loan does not cover expenses during the design phase—in fact, in most cases, you need the building plans beforehand to apply for the loan.

If there are leftover funds after your construction is over, the lender will generally not release them. The restriction is hardly an issue, though, as you only pay interest on the amount you’ve drawn to date.

Types of Construction Loans

A variety of construction loan packages are available to suit different borrowing needs. Most lenders offer four forms of construction financing, presented in detail in the table below:

Loan TypeSuitable ForDetails
Stand-alone construction loanInvestors who don’t need a permanent mortgageThe lender will only cover the construction costs, expecting you to pay the mortgage in full at the end of the tenure (usually one year). This package works for investors because they can sell the finished residence to settle the loan
Construction-to-permanent loanHomeowners or rental property owners who want the construction loan to be rolled into a mortgageA construction-to-permanent loan streamlines the financing process for homeowners who will be seeking a mortgage for the finished residence. The down payment requirement is usually larger than for other construction packages, but you benefit by:
Saving time on future mortgage-hunting
Paying only one set of closing costs
Owner-builder construction loanBorrowers qualified to be the contractor/builder of the propertyAn owner-builder loan allows you to act as the contractor of the project. To qualify, you need to prove you have the expertise, education, and necessary licensing to execute the project
End loanBorrowers looking to pay off the construction loan by taking a long-term loanAn end loan is used to replace a short-term loan with a long-term one. If you take a construction loan coupled with an end loan, you can switch to a long-term repayment plan with the same lender once the construction is over. It’s similar to a construction-to-permanent loan, but end loans are used mainly by investors

How To Qualify for a Construction Loan—Requirements Dictated by Different Lenders

The qualification requirements for construction loans depend on the lending channel you choose. You can go for:

  1. Conventional construction bank loan
  2. Federal Housing Administration (FHA)-backed construction loan
  3. Hard money construction loan

While home mortgage products are more or less the same (regardless of the lender), you need to be more discerning with construction loans. It’s common for borrowers to get frustrated due to mid-construction funding delays, often caused by inspection hassles. The worst part is that you may have to bear larger material and labor costs due to delays, and the difference is usually not cushioned by the loan.

The following sections summarize the eligibility criteria and other logistical details for different lenders to help you determine where to get a construction loan from.

Source: Magnet.me

Conventional Construction Loans—Requirements

Conventional lenders are primarily regional and national banks running specific construction financing programs. You must be considered financially stable by the lender to qualify. The general eligibility standards are:

  • Credit score of 680 or higher
  • Debt-to-income (DTI) ratio of 45% or lower
  • Equity input (down payment) of 20% or more

If you opt for conventional financing, you may have to go through a construction loan pre-approval process to figure out your borrowing capacity. The pre-approval screening is not the same for every bank—in most cases, a loan officer checks out your projections or talks to your builder to come up with how much you can borrow. Once you get the approval, you can contact an architect or design team to work out the plans according to your budget.

After your plans are ready, apply for a conventional construction loan by preparing the following documents:

  1. Plot details (purchase deed, protective covenants, etc.)
  2. Descriptive responsibilities of the architect, general contractor, construction manager, or owner-builder (as the case may be)
  3. Contractor’s resume
  4. A signed construction contract
  5. Property insurance certificate
  6. Credit and banking details
  7. Property blueprints and overall budget
  8. Materials list and projected labor cost (in a format specified by the bank)
  9. An estimated draw schedule (that aligns with the bank’s disbursement policy)
  10. Start and completion dates with provisions for change

It takes a bank about 30–90 days to review the documents and approve the loan. The draw amounts are deposited with the contractor after satisfactory inspection proceedings.

FHA Home Construction Loans Eligibility Criteria 

FHA construction loans are serviced by banks and other mortgage companies. They come with low interest rates and are suitable for borrowers who:

Since these loans are insured by FHA, financiers are ready to lend at a higher risk. To qualify, you need to have:

  • Credit score of at least 500
  • DTI ratio of 43% or less
  • Two years of steady employment (in the same field)
  • Qualifying land
  • A licensed contractor and construction plans
  • Ongoing mortgage insurance premium

FHA-backed construction loans require the borrower to live in at least one unit of the finished residence—you cannot use it as a vacation home or an investment holding. You may choose between an FHA construction-to-permanent loan or a 203(k) rehab loan, depending on your property needs. While there is no income limit to apply for these loans, you cannot borrow enough for luxury homes. Here’s a 2022 estimate of the FHA fund capping for housing properties with 1–4 units:

Number of Housing UnitsBase Limit*Limit in High-Cost Areas*Limit for Alaska, Hawaii, Guam, and the U.S. Virgin Islands
1$420,680$970,800$1,456,200
2$538,650$1,243,050$1,864,575
3$651,050$1,502,475$2,253,700
4$809,150$1,867,275$2,800,900

*For all of the U.S. except for Alaska, Hawaii, Guam, and the U.S. Virgin Islands

Getting approved for FHA loans can take up to 90 days because of erratic bureaucratic screening.

Hard Money Loans—Qualifications

Hard money financing has gained momentum as a fast-paced private funding solution, making it the best way to get a construction loan in the current market. These are short-term loans 100% backed by “hard assets,” which can be the qualifying land or some other property the borrower owns. Since the risk exposure is fully mitigated by the collateral, hard money lenders provide financing with minimum regulatory scrutiny and red-tapism.

Borrowers can qualify for a hard money construction loan regardless of their financial background and current debt obligations. The paperwork is light, and while every lender states different application requirements, your chances of approval are generally high if you submit detailed construction plans. Once approved, you can collect the funds within days and kickstart your project on time.

Source: RODNAE Productions

Hard money loans are particularly useful for homeowners and builders operating within strict time and budget constraints. In case the property is meant to be self-occupied or rented out in the future, you can refinance the hard money loan with permanent/long-term financing from a traditional or government-backed lender.

Hard money loans are tools of convenience, which makes them 0.5%–5% pricier than the traditional construction financing available in your state. The loan terms are not uniform across lenders, so before you choose a financier, talk to them about:

  • Down payment needed
  • Construction fund disbursal plan
  • Expected inspections
  • Extension provisions for exceeding the project timeline

Discover Efficient Construction Loan Financing With Hard Money Loan Solutions

Construction projects can be volatile and challenging—you need a reliable and understanding lender to get you through without hiccups. Trust Hard Money Loan Solutions (HMLS) to be the ultimate financier for all your building plans!

HML Solutions values time-sensitive funding for construction loans like no other. Whether you have a deadline or are worried about rising material costs, contact HMLS lending group to get a quick (and free) consultancy on your situation. The group offers various construction loan packages catered to investors, businesses, and homeowners for any kind of real estate, including multi-unit homes and commercial structures.

HML Solutions has made quite a mark in the hard money lending industry. It has a Google service rating of 5 stars, with borrowers praising the group for:

  • Being transparent throughout the decision-making process
  • Funding difficult deals rejected by most lenders
  • Financing quickly, often within 3–10 days
  • Requiring less qualifying paperwork than competitors

Many private lenders cancel approved construction loans when newer risks emerge, leaving the borrower hapless. HMLS lenders never back out of a funding commitment once a loan is approved because they calculate all potential risk variables beforehand. That being said, they follow a flexible lending approach and allow borrowers to share what kind of loan structure they would prefer before setting up a customized loan program.

Source: Kampus Production

Besides construction, HML Solutions also offers loan packages for:

How Much Are Interest Payments on an HMLS Construction Loan?

Interest rates at HMLS vary according to borrower qualifications but are fair and well-researched. The group is backed by veteran lenders and investors who have been in the real estate market for years. They are motivated to service competitive and quality deals and typically charge interest between 9.99% and 12% (fixed).

At HML Solutions, you pay monthly interest-only payments. You can repay the principal sum at the end of the tenure or get a refinancing solution with a traditional lender. There will be no penalty charges if you choose to repay anytime after six months of taking the loan.

You can go through the borrowing limits and other terms of a sample HMLS loan package in the table below:

ParametersHML Solutions Lending Terms
Down paymentNot required
Loan principal$100,000–$50,000,000
Term1–3 years
Loan-to-value or LTV servicedUp to 70% of the current purchase price or appraised asset value (whichever is lower)
Origination fee2 points or 2%
Closing time3 days to 2 weeks
AmortizationNo

HMLS lenders are upfront about your immediate and future outflows so that you have a clear picture of your cost obligations from the get-go. As far as fund disbursal is concerned, the group typically releases the entire loan funds at once, directly to the borrower. Unlike traditional lenders, HML Solutions doesn’t hover over you with intrusive inspections as long as you keep up with your payments.

Apply for an HML Solutions construction loan today to fulfill your funding requirement at the earliest!

What Are the Steps to Getting a Construction Loan at HML Solutions?

The construction loan approval process at HML Solutions starts the moment you apply for financing. Here are the steps involved:

  1. Access HML Solution’s online loan application form
  2. Enter the following information:
    1. Basic personal/business particulars
    2. Contact info
    3. Property details
  3. Attach a construction plan (if available)
  4. Submit the form and wait for a lender to contact you
  5. Answer the lender’s questions over the phone
  6. Get an answer on whether the loan would be serviceable

If the HMLS group finds your deal appealing, they may conduct a collateral appraisal before the final approval. In general, any applicant who has enough equity in the property and is okay with the LTV offered is accepted.

HMLS lenders deal with borrowers from all economic classes prejudice-free. If, for any reason, they cannot fund a project, they communicate with honesty and try to advise the applicant on other borrowing channels available, if any.

Source: RODNAE Productions

Can a First-Time Home Buyer Get a Construction Loan?

If you’re a first-time home buyer, you may be conflicted between getting a readymade unit or building something that appeals to your aesthetics. Construction loans are available to anyone who meets the qualification requirements—it’s the construction element in itself that can be overwhelming for someone with little to no building experience.

If you want to build your own home for the first time, start by researching the construction timeline and familiarize yourself with the core aspects of the process. Be diligent while choosing a:

  • Contractor—Interview at least 3–5 contractors to evaluate your options in terms of availability, fees, types of services, reliability, and experience with relevant properties
  • Lender—If you’re going for a traditional construction loan, you may want to work with regional banks that have more consideration for local issues like environmental factors, labor strikes, or transport logistics. In case you decide to take a hard money loan, opt for lenders with good customer ratings

Consult with Hard Money Loan Solutions if you’ve trouble understanding any borrowing issue as a first-time navigator of construction loans.

Featured image source: Pixabay

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