New home construction loans are often also referred to as self-build loans and are specifically issued to allow borrowers to finance the purchase of a lot intended for residential development and to finance the cost of the home’s construction.
How New Home Construction Loans Work
New home construction loans work similar to interest only loans—while the home is being built, the borrow is only required to make small payments towards the interest accruing on the loan. At the end of the build, the remaining loan balance is due (or can be refinanced into a new home loan).
These loans are a convenient option for borrowers wanting to build their dream home or have a home built in their ideal location; however, because there is not already a structure to serve as collateral, these loans are a higher risk for lenders and may have higher interest rates (and variable interest rates) or fees associate with issuing the loan to minimize the financial risk for the lender.
Depending on the mortgage loan program you choose to build your own home, the down payment and other qualifications may vary. Some require as little as 10% down while others may opt for the standard 20%—or as high as 30%.
In addition, these loans are not dispersed to the borrower but rather directly to the builder—and often in installment payments with an initial large payment upfront to cover the cost of the materials needed to begin building.
Types of New Home Construction Loans
Borrowers can choose from four different mortgage loan programs for building their own home. Each works a little bit different and may work better over another depending on your specific building needs.
- Construction Only Loans: This loan type is split into two separate loans. The first is a loan to cover the cost of construction—labor, materials, permits, etc. This loan requires a small down payment made by the borrower and has a short term, usually a year or less—just long enough to build the home. Then as second loan is borrowed that pays off the construction loan and becomes your new traditional fixed-rate mortgage. Since the loans are handled separately, you have two different closings and may have two different lenders (one that provides the construction loan and the other that provides the mortgage).
- Construction-To-Permanent: This loan type takes the above and rolls the loans into each other to avoid having two separate closings and lenders. Typically, during the construction phase the borrower will have to make interest only payments with a variable interest rate and then when the construction is completed, the loan is converted into a fixed-rate mortgage with a 30-year term. Borrowers can opt for their permanent loan to have a variable rate and/or a 15-year term.
- End Loan: In this case, the builder covers the cost of constructing a new home and the borrower purchases it from the builder by applying for a traditional mortgage.
- Owner-Builder Construction Loan: Home builders can choose to build their own home and take out a special mortgage to cover the cost of building the home themselves; however, lenders will require proof of construction experience and/or licensing before approving this type of loan.