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As the name implies, a construction loan is generally used only during the construction of a home or building. Once the home is built, the borrower may have to pay off the construction loan. Mortgage loans are only available for homes that are already built and livable.
This chart shows the basic differences between construction loans and mortgage loans.
Construction loans |
Traditional mortgage loans |
|---|---|
1. Short-term (potentially 12 to 24 months) |
1. Long-term (potentially 15 to 30 years) |
2. Disbursement of funds follows the progress of the home |
2. All funds are disbursed when the loan is opened to cover the purchase of the home |
3. Available only for homes or buildings under construction |
3. Available only for homes that are completed and habitable |
|
4. Interest rates often lower than construction loans |
Construction Loans
When comparing a construction loan vs. a mortgage loan, one of the biggest differences tends to be that construction loans are not secured by a completed house. Mortgage loans, on the other hand, are often secured by the home being purchased. Here are some other key differences:
Different timeline
Construction loans by design are short-term, as they are meant to last only as long as it takes for the construction project to be completed. As construction progresses, funds from the construction loan may be released in a series of disbursements. The disbursement of funds may also differ across lenders, so it is important to thoroughly research options before deciding where to get financing.
When the home’s construction is complete, the borrower may pay off the balance of the construction loan with a lump sum or, in some cases, convert it to a conventional mortgage loan.
Varying approval process
The approval process for a construction loan may be different than a conventional mortgage loan. For both types of loans, a lender may consider factors like the borrower’s credit score, debt-to-income (DTI) ratio, and down payment.
For a construction loan, lenders may consider the builder who will be constructing the home and the construction plans, including blueprints, budget, and builder payment schedule.
Short-term
Repayment terms for construction loans tend to be much shorter than mortgage loan repayment terms. That’s because the construction loan only lasts throughout the building of the house — potentially 12 to 24 months. A mortgage loan, on the other hand, is a long-term financing vehicle, with repayment terms usually from 15 to 30 years.
Higher interest rates or down payments
Construction financing may cost more than a mortgage loan because lenders might classify this type of financing as riskier, given they may not have a finished product to serve as collateral for the funds. A construction loan may require higher interest rates and larger down payments to lessen that risk.
Disbursed in phases
With a construction loan, the lender can disburse funds at the completion of each phase of construction or as additional funds are needed. The borrower’s interest payments only cover interest on the amount that has been disbursed, much like the interest payments on a line of credit.
The disbursement schedule may be different with a mortgage. In that case, all the money from the loan is paid out upfront, covering the entire cost of the home at once. The borrower will then pay back the principal, interest, and any additional fees agreed upon over the set repayment period the lender has provided.
Traditional Mortgage Loans
Traditional mortgage loans are a form of secured financing because they are secured by the tangible asset, the home that they will finance.
Mortgages are long-term loans and are only available to finance homes that are already constructed. Borrowers who finance the building of a new home with a construction loan may take out a mortgage loan when the construction on their home is finished or convert the construction loan to a more traditional mortgage loan.
Application process
A mortgage loan may require a different application process compared to a construction loan. That’s because a construction loan requires borrowers to submit detailed information about the planned construction, such as house plans, builder contract, project budget, and draw schedule.
Long-term repayment
Mortgages can offer a long-term repayment of 15 to 30 years. Construction loans are short-term loans, with a repayment term of 12 to 24 months in many cases. That’s because construction loans must be repaid when the home construction is complete, but mortgages finance a completed house over the long term.
Consumer protections
The federal government affects the traditional mortgage market through the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac). The Federal Reserve also influences current mortgage rates by setting the federal funds rate.
There is no standardized government involvement with construction loans.
Financing New Construction Projects
For anyone looking to finance a new construction project, a construction loan rather than a traditional mortgage may be preferred. Because a construction loan often requires interest-only payments until the project is complete, it may prove helpful for managing construction business cash flow.
Business owners and aspiring homeowners may also be able to use personal or business loans that are not industry-specific to fund the construction of a new home or facility, so long as the loan agreement they sign with their lender allows for the funds to be used in that way.
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