How Much Is a Construction Loan?

A construction loan is a specialized financial product designed to fund new construction or substantial renovations. Unlike a traditional mortgage, these temporary loans are tailored to the unique progression of a building project. The financial commitment involves various costs and processes beyond the principal amount.

Key Cost Components

The total cost of a construction loan involves several financial elements beyond the primary loan amount. The interest rate is a significant factor, as construction loans typically feature variable rates, often higher than traditional mortgages due to increased risk for lenders. These rates are commonly set as a margin above a benchmark rate, such as the prime rate, and generally range from 6% to 11.5%. Interest is usually paid on an interest-only basis during the construction phase, applying only to disbursed funds.

Beyond interest, various fees contribute to upfront and ongoing costs. An origination fee, charged by the lender for processing the loan, typically ranges from 0.5% to 2% of the total loan amount. Appraisal fees cover initial and completion appraisals, which can range from $200 to over $1,000 depending on project complexity. These appraisals determine the property’s value before and after construction.

Borrowers also encounter inspection fees, which lenders charge for verifying construction progress. Title insurance protects both the lender and borrower from property title defects, often costing around 0.75% of the loan amount. Additional closing costs can include legal fees, survey fees ranging from $600 to $1,000, and new construction escrows for taxes and insurance. These cumulative fees can total 1% to 6% of the loan amount.

A down payment is another financial requirement for most construction loans, typically ranging from 10% to 20% of the total project cost. Some lenders may require higher percentages, reflecting the higher risk. Government-backed options, such as FHA construction loans, may offer lower down payment requirements, sometimes as low as 3.5% for qualified borrowers. A larger down payment generally leads to more favorable loan terms and a higher likelihood of approval.

Factors Influencing Loan Size

The maximum amount a lender is willing to provide for a construction loan is shaped by several key factors. The project’s “as-completed” appraised value is a primary determinant. Lenders assess what the property is projected to be worth once construction is finished, using detailed building plans, specifications, and a cost breakdown for this assessment. The loan amount is usually based on a percentage of this projected value or the total project cost, whichever is lower.

The financial health of the borrower plays a substantial role in determining both the loan amount and the terms offered. Lenders scrutinize credit scores, typically seeking a minimum score of 620, with scores of 740 and above often leading to more favorable interest rates. A borrower’s debt-to-income (DTI) ratio measures monthly debt obligations against gross monthly income. Conventional lenders generally prefer a DTI ratio below 45%, though some may allow up to 50% for certain loan types.

Income stability and available financial reserves also influence a lender’s decision. Consistent income demonstrates the ability to manage loan payments, while reserves provide a buffer against unexpected construction costs or delays. A robust financial profile, characterized by a higher credit score, lower DTI, and sufficient reserves, can enhance a borrower’s eligibility for larger loan amounts and more competitive interest rates. This financial assessment helps lenders mitigate the inherent risks of construction financing.

Loan-to-value (LTV) ratios are applied to construction loans based on the projected finished value of the property. For 1-4 family residential construction, supervisory LTV limits typically range from 75% to 85%. This means a lender might finance up to 85% of the “as-completed” appraised value, requiring the borrower to cover the remaining percentage through a down payment or equity in the land. A lower LTV, signifying a larger borrower equity contribution, generally reduces perceived risk for the lender.

Broader market conditions also influence construction loan availability and terms. Prevailing interest rates, set by economic factors and central bank policies, affect the cost of borrowing for both lenders and consumers. Local construction costs, including labor and materials, directly impact the total project budget and, consequently, the required loan amount. The overall strength and stability of the real estate market in a specific area can also influence a lender’s willingness to finance new construction projects.

Understanding Loan Disbursements

Construction loan funds are disbursed through a structured process known as a draw schedule. This schedule outlines when funds are released to the borrower or builder, tied to specific construction milestones. Common milestones include pouring the foundation, completion of framing, rough-ins for electrical and plumbing, exterior finishing, and final completion. Each draw request must correspond to work completed and costs incurred.

Before each disbursement, lenders require inspections to verify that milestones have been met according to approved plans and budget. These inspections ensure the project progresses as planned and funds are used appropriately. This oversight helps prevent significant deviations from the original project scope.

Interest on a construction loan accrues only on the funds already disbursed. As construction progresses and more funds are drawn, the outstanding loan balance and interest payments grow. This interest-only payment structure during the build phase can provide cash flow relief to borrowers, who may also be covering temporary housing costs.

Managing the construction budget with the draw schedule is important for avoiding cost overruns. Borrowers and builders must track expenses to ensure the project stays within its financial parameters. An efficient draw schedule, accounting for expected costs and providing clear payment milestones, helps maintain project momentum and financial control.

Securing Permanent Financing

Since construction loans are temporary, securing permanent financing is a final step. This transition can occur through different structures, each with distinct cost implications.

One-Time Close Loan

A construction-to-permanent loan, also known as a one-time close loan, automatically converts into a long-term mortgage upon project completion. This requires a single application and closing process. The primary advantage is reduced closing costs, as the borrower pays fees only once for both construction and permanent financing. This streamlined process also simplifies qualification, as the borrower is approved for both phases upfront. Some one-time close loans offer the ability to lock in an interest rate at the outset, protecting the borrower from potential rate increases during construction.

Two-Time Close Loan

A two-time close loan involves two separate transactions: one for short-term construction financing and a new application and closing for a permanent mortgage once the home is built. This option provides flexibility, allowing borrowers to shop for competitive mortgage rates after construction is complete. However, the borrower incurs duplicate closing costs and fees, as both loans require their own set of expenses. A two-time close also introduces the risk of interest rate fluctuations between closings and the need to re-qualify for the permanent loan. Borrowers might also consider refinancing an existing construction loan into a new permanent mortgage if market interest rates decline significantly after the initial construction loan was secured.