What Is a Construction-Only Loan? Everything You Need to Know
If you’re planning to build a custom home from the ground up, you may come across a financing option called a construction-only loan. This unique loan type plays a crucial role in real estate development and new home construction—but it’s not the same as a traditional mortgage.
In this blog post, we’ll explore what a construction-only loan is, how it works, its benefits and drawbacks, and how it compares to other types of construction financing. Whether you’re a first-time home builder or a real estate investor, understanding construction-only loans can help you make smarter financial decisions.
What Is a Construction-Only Loan?
It is a short-term loan used exclusively to finance the building of a new residential or commercial property. Unlike a traditional mortgage that covers the purchase of an existing home, a construction-only loan provides funding only during the construction phase of a project.
Once the construction is complete, the borrower must either:
- Pay the loan off in full (typically through cash or refinancing), or
- Convert it into a long-term mortgage through a separate loan process.
How the Loan Works
Construction-only loans are typically issued for a period of 6 to 12 months. The lender releases the funds in stages, known as “draws,” based on the progress of construction milestones. These draws are usually inspected and approved before funds are released to ensure the project is on track.
Key Components:
- Short-term duration: Usually 12 months or less.
- Interest-only payments: Borrowers pay only the interest during construction.
- Higher interest rates: Due to increased lender risk.
- Staged disbursements: Funds are paid out incrementally.
Benefits of a Construction-Only Loan
The Loans offer several advantages, especially for those building a custom home or managing a detailed development timeline.
1. Flexible Payment Structure
You only pay interest during construction, which can be easier on your budget. This can help reduce your monthly outflow until the home is fully built.
2. Detailed Oversight
Funds are released based on construction milestones, giving both the lender and borrower a structured timeline. This system helps keep the project accountable and on budget.
3. Ideal for Custom Builds
If you’re working with a builder and designing a home to your specifications, a construction-only loan allows you to finance the project phase by phase without committing to a full mortgage upfront.
Drawbacks of a Construction-Only Loan
While construction-only loans offer flexibility, they also come with certain disadvantages that borrowers should be aware of.
1. Two Closings Required
Unlike a construction-to-permanent loan, a construction-only loan requires two separate closings:
- One for the construction loan.
- Another for the permanent mortgage (unless you pay off the loan in cash).
Each closing involves fees, time, and paperwork, which can add to your total costs.
2. Qualification Challenges
Lenders see construction loans as higher risk, so they often require:
- Higher credit scores
- Lower debt-to-income ratios
- Substantial documentation of plans, costs, and the builder’s credentials
3. Uncertainty in Mortgage Approval
There’s a risk that you might not qualify for a long-term mortgage when construction is finished. If your financial situation changes during the build, you may find it difficult to refinance the construction loan.
Construction-Only Loan vs. Construction-to-Permanent Loan
If you’re evaluating construction financing, you may also come across the construction-to-permanent loan. Here’s a quick comparison to help you decide which option suits you best:
| Feature | Construction-Only Loan | Construction-to-Permanent Loan |
|---|---|---|
| Loan Term | Short-term (6-12 months) | Long-term (construction + mortgage) |
| Closings Required | Two | One |
| Interest Rate | Typically higher | Can be locked in at start |
| Conversion to Mortgage | Requires refinancing | Converts automatically |
| Best for | Those with large cash reserves or uncertain long-term plans | Those wanting a single financing package |
Who Should Consider a Construction-Only Loan?
Construction-only loans are best for:
- Experienced home builders or investors who want control over each phase of the project.
- Borrowers with strong financial profiles who are confident they can refinance or pay off the loan after construction.
- Clients building on owned land who only need temporary funding.
- People planning to sell quickly after construction, avoiding the need for a long-term mortgage.
Requirements for Loan Qualification
To get approved for a construction-only loan, lenders typically require:
- Excellent credit score (usually 680+)
- Stable income and low debt-to-income ratio
- Detailed construction plans and timeline
- Licensed and reputable builder
- Down payment of at least 20% (sometimes more)
Lenders also inspect the construction site regularly to verify progress before releasing each draw.
Tips for Managing the Loan
- Work with a trusted contractor. Make sure your builder is experienced and has a track record of completing projects on time.
- Keep extra cash on hand. Unexpected costs often arise during construction.
- Stay organized. Track all expenses, permits, inspections, and draw schedules.
- Get pre-approved for the long-term mortgage. If you’re planning to refinance, get pre-qualified early to reduce the risk of rejection after construction ends.
Final Thoughts: Is a Construction-Only Loan Right for You?
This type of loan offers a valuable financing solution for individuals looking to custom-build a home or embark on a real estate development project. While it provides flexibility and control, it also comes with higher risks and costs compared to other financing options.
If you’re financially stable, working with a reliable builder, and prepared for the responsibilities of managing a construction project, a construction-only loan can be a smart way to bring your dream home or investment to life.
Frequently Asked Questions (FAQ)
Q: Do I need a construction-only loan if I’m buying a newly built home?
No. If the home is already built or being built by a developer, you typically just need a traditional mortgage.
Q: Can I use this type of loan for a commercial property?
Yes, loans are available for both residential and commercial construction, but terms may vary.
Q: Can I lock in my mortgage rate during the construction-only phase?
No. Since it’s a separate loan, your mortgage rate will be determined when you apply for the permanent financing.