Consider Construction Loan
For larger additions or when home equity isn't available, a construction loan provides financing specifically designed for building projects. These specialized loans work differently from traditional financing—here's what you need to know.
Quick Summary
Typical rates
Prime + 1-2%
Best for
$150K+ projects
Approval time
30-60 days
What Is a Construction Loan?
A construction loan is short-term financing that covers building costs during construction. Unlike a HELOC where you draw funds freely, construction loans release money in stages as work is completed and inspected.
Key Difference
Construction loans are designed for building projects and include lender oversight of your contractor's work. This adds protection but also complexity compared to simpler home equity products.
Types of Construction Loans
Construction-to-Permanent Loan
The most common choice for homeowners. This single loan covers both construction and long-term financing, automatically converting to a traditional mortgage when building is complete.
Pros: One application, one closing, lower total fees
Cons: Locked into permanent rate set at closing
Stand-Alone Construction Loan
A separate short-term loan just for construction. When building is complete, you refinance into a permanent mortgage. This gives more flexibility but requires two separate closings.
Pros: Shop for best permanent rate after construction
Cons: Two closings, higher total fees, rate risk
Renovation Loan (FHA 203k or Fannie Mae HomeStyle)
Government-backed options that roll renovation costs into your mortgage. Lower down payments and more flexible qualification, but with more paperwork and restrictions.
Pros: Lower down payment (3.5-5%), easier to qualify
Cons: More paperwork, contractor restrictions, mortgage insurance
How Progress Payments (Draws) Work
Construction loans don't give you a lump sum. Instead, funds are released in "draws" as construction progresses. This protects both you and the lender.
Typical Draw Schedule
Draw 1: Foundation
Foundation poured and inspected
Draw 2: Framing
Structure framed and roofed
Draw 3: Rough-In
Electrical, plumbing, HVAC roughed in
Draw 4: Drywall & Finishes
Walls, flooring, cabinets installed
Draw 5: Final
Project complete, final inspection passed
Draw Inspection Required
Before each draw, the lender sends an inspector to verify work is complete. This adds a few days to each payment cycle—make sure your contractor understands this timeline.
Interest-Only Payments During Construction
One major advantage of construction loans: you only pay interest on money that's been drawn, not the full loan amount. This keeps payments manageable during building.
Example: $200,000 Construction Loan at 9%
Budget tip: Your interest payments will increase with each draw. Budget for average interest costs over the construction period, not just the initial payment amount.
Construction Loan vs. HELOC: Which Is Better?
| Factor | HELOC | Construction Loan |
|---|---|---|
| Best for amounts | $50K-$150K | $150K+ |
| Approval complexity | Simple | Complex |
| Fund access | Draw anytime | Draws with inspections |
| Contractor oversight | None | Lender verifies work |
| Typical rates | Prime + 0-2% | Prime + 1-2% |
| Closing costs | $0-$500 | $3,000-$10,000 |
Rule of thumb: If you have sufficient equity and your project is under $150,000, a HELOC is usually simpler and cheaper. For larger projects or when equity is limited, construction loans become more attractive.
What Lenders Require
Construction loans have stricter requirements than standard mortgages or HELOCs. Be prepared to provide extensive documentation.
About You
- • Credit score: 680+ (700+ preferred)
- • Down payment: 10-20% of total project
- • Debt-to-income: Under 43%
- • Cash reserves: 6+ months payments
- • Stable employment (2+ years)
About the Project
- • Detailed construction plans
- • Licensed contractor with references
- • Fixed-price contract (cost-plus risky)
- • Builder's risk insurance
- • Realistic construction timeline
Frequently Asked Questions
Can I act as my own general contractor with a construction loan?
Most lenders require a licensed general contractor. "Owner-builder" construction loans exist but typically require construction experience, higher down payments (25-30%), and are harder to find. For a home addition, using a licensed GC is usually required.
What happens if construction goes over budget?
This is one of the biggest risks. If your project exceeds the loan amount, you'll need to cover the difference out of pocket or try to modify the loan (difficult mid-construction). Build a strong contingency into your budget before applying.
How long is the construction period on the loan?
Most construction loans allow 12-18 months for completion. Home additions typically take 3-6 months, so this is usually sufficient. Extensions are possible but may incur fees and require lender approval.
Do I need to pay off my existing mortgage first?
No—construction-to-permanent loans typically pay off your existing mortgage and roll everything into the new loan. You'll have one mortgage payment that includes both your original home and the addition.
Ready for the Next Step?
Regardless of how you finance your addition, building a contingency buffer is essential. Learn why 20% is the magic number and how to protect yourself from budget overruns.