Many homebuyers are turning to new construction because home resales are limited: homeowners reluctant to give up low mortgage rates have been staying put on their land for a record 11 years.[1] Further straining the housing supply is that single-family new construction has also declined in recent years.[2]
Building a new home is also attractive for other reasons, including endless customization possibilities and the ability to sidestep the upgrades, repairs, and sweat equity many existing homes require.
But building a home typically requires a construction loan, which works very differently from a traditional mortgage. Here's what you need to know about how these loans differ and which is right for you.
Construction loans vs. mortgages: Key differences
The main difference between construction and mortgage loans lies in their use and terms. Construction loans finance new home builds or large-scale renovations through a short-term loan that typically lasts a year.
Mortgages are long-term loans (typically for 15 or 30 years) with fixed interest rates. If you can’t make the payments, the lender may put your loan into foreclosure.
You need two loans when constructing your home (and will potentially pay two sets of closing costs): the short-term construction loan and a long-term mortgage loan.
Here’s a chart further detailing the differences between construction loans and mortgages.
| Construction loan | Mortgage | |
|---|---|---|
| Available for | New builds, major renovations | Already built homes |
| Loan types | Construction-only; construction-to-permanent | Fixed-rate; ARM; government-backed |
| Costs covered | Land, labor, materials; sometimes permits and design fees | Home purchase price |
| Funds paid out | Typically in 4-6 stages (draws) | Lump sum at closing |
| Collateral | Land and under-construction home | Completed home |
| Interest rates | Fixed or variable, depending on the loan; generally about 1% higher than a mortgage but depends on the lender | Fixed or variable; usually lower rates |
| Fees | May pay closing costs twice with construction-only loan; fees for inspections and draws | Around 3-5% of the purchase |
| Repayment | Interest-only, then converts into mortgage or is paid off | Monthly principal + interest |
| Term length | Short-term (6–18 months) | Long-term (15–30 years) |
| Down payment | Typically 20% or more; land equity may apply toward down payment and some construction loans require lower down payments | 3-20%, depending on the loan |
| Credit score | Typically 680+, but depends on the lender and can be lower with government-backed loans | Varies by loan type |
How to decide if a construction loan or mortgage is right for you
Deciding between a construction loan and a mortgage comes down to the kind of house you want. If you want to build from the ground up with full control, a construction loan is your likely path. If you want to purchase an already-built home or one that a builder finances to construct, you’ll need a mortgage at some point.
Beyond that, your credit profile, financial reserves, risk tolerance and other financial and personal factors can sway your decision.
You should consider a construction loan if you . . .
- Already own the land
- Can’t find an existing home on the market you like within your budget
- Have strong cash reserves to cover cost overruns and dual housing payments
“When you’re getting a construction loan...you’re qualifying to borrow money to complete a project,” says Matt Schwartz, Mortgage Broker and co-founder of VA Loan Network. He warns clients to watch out for cost overruns, draw schedules, and timelines. “When construction takes longer than expected, the borrower pays the extra costs, not the bank.”
You should consider a mortgage loan if you want . . .
- To move in quickly without waiting for construction
- Fixed financing costs set at closing
- To generally pay a lower interest rate on your loan
- Access to first-time homebuyer or down payment assistance programs if you qualify
Your options for first-time homebuyer or down payment assistance programs are generally more limited with construction loans, which often require higher down payments, variable rates during the build, and stricter qualification standards. If predictability, affordability, and faster move-in timelines matter more to you than customizing your home from the ground up, a traditional mortgage is the simpler and less risky path.
What can you use a construction loan for that you can’t use a mortgage for?
Construction loans are for properties that don’t exist yet, so they cover purchases that a mortgage won’t. For starters, you can use construction loans for commercial properties, like office buildings, retail spaces, and more while most mortgages are limited to residential properties.
And unlike mortgages, construction loans can cover land and construction costs (labor, building materials, and permits) for new homes or extensive renovations. Construction loans also pay builders, suppliers, and subcontractors.
| Use | Construction loan | Traditional mortgage |
| Buy vacant land | ✅ | ❌ |
| Build a new home | ✅ | ❌ |
| Pay construction costs (labor, materials, permits) | ✅ | ❌ |
| Pay builders and subcontractors via draw schedule | ✅ | ❌ |
| Finance major structural renovations | ✅ | ❌ |
| Buy a move-in-ready home | ❌ | ✅ |
| Refinance an existing home | ❌ | ✅ |
| Use for commercial properties | ✅ | ❌ |
What is the difference between applying for a construction loan and a mortgage?
Lenders consider typical approval factors for both types of loans: credit, ability to repay (income, DTI, employment history), and funds (down payment, savings, readily liquidated assets).
However, construction loans are “harder to qualify for because you need good credit, good reserves, and a licensed, approved builder that has a good history,” says Schwartz.
The lender also wants details on permits, the home’s builder, and construction plans (budget, blueprints, timelines, and builder payment schedules). “The home that you’re building needs to be fully defined,” says Schwartz.
Construction-only loans vs. construction-to-permanent loans
Construction-only loans have variable interest rates and require refinancing into a mortgage when the term ends, meaning there’s another approval process and additional closing costs.
Construction-to-permanent loans help mitigate uncertainty by offering locked rates, a single closing, and automatic conversion to a traditional mortgage. Construction-to-permanent loans are sometimes more easily found at small regional banks.
Important note: You may not qualify for a mortgage when your house is complete if your finances or the market changes. In 2023, almost 1.3 million households were priced out of the market when rates increased just a quarter point.[3] Always discuss different scenarios with your lender and how you can prepare for them to make sure it all goes smoothly.
Construction loan: How it works
Say you found the perfect lot to build your dream home and decide to take out a construction-to-permanent loan. The bank releases funds in stages based on construction milestones, like the foundation or framing completion.
During construction, you make interest-only payments on drawn funds. For example, on a $400,000 balance with a 7.5% interest rate, your monthly interest-only payment would be $2,500 if the full $400,000 balance was drawn. Generally, since the funds are released in phases, your payments won’t start off that high when you first take the loan. But they’ll increase as you continue to borrow for the build.
Vanessa Lemieux, a Florida realtor with Royal Shell Real Estate, notes that most people pay rent or a mortgage on their current home, plus interest-only payments on the construction loan. “Alternatively, [with] a spec home, you’re buying a brand-new finished product that is typically move-in ready. In this scenario, most times, there isn’t a crossover of timelines where you would be making both payments.”
Once the house is finished and issued a certificate of occupancy, your construction loan converts to a traditional mortgage with regular monthly payments.
Mortgage loan: How it works
If you opt for a home already on the market or need to refinance your construction-only loan, you’ll typically use a traditional mortgage loan.
You’ll provide your lender with documentation like pay stubs, W-2s, tax returns, and bank statements. The lender will also require an appraisal and proof of homeowners insurance.
Once approved, you set a closing date to make your down payment, pay closing costs, and sign paperwork. Then you’ll start making monthly mortgage payments.
On a 30-year mortgage with a $400,000 loan and 6.5% interest rate, you’d pay around $2,530 toward your principal and interest. Keep in mind that’s before adding in property taxes, homeowners insurance, HOA fees, and PMI if you have it.
Builder-financed homes: An alternative to construction loans
With builder-financed homes, the builder owns the land and assumes all risks during a home’s construction until the project is completed—no construction loan required. This option is popular in large residential developments.
I bought my home this way, selecting the lot, floor plan, and finishes from the builder’s options. We put down $10,000 at signing and another $10,000 within 30 days. Once complete, we closed on our mortgage with the deposits credited. The process took 6.5 months and required minimal oversight from us.
Greg Healing, an eXp realtor specializing in builder-financed homes at Babcock Ranch, a master-planned community in Florida, notes that interest in custom builds is waning, with more buyers choosing spec homes (move-in-ready new construction) or quick move-ins (homes with customizable final touches).
“Builders working toward sales quotas are heavily discounting homes, which is why buyers typically choose spec homes or quick move-ins over building from the ground up,” Healing says.
Ready to talk to a loan officer?
Choosing between a construction loan and a mortgage comes down to whether you’re financing a home’s build or purchasing an existing one, your financial standing, and your budget.
At the end of the day, there are so many variables that go into deciding which option is right for you. The best way to decide is to meet with a loan officer who can dive in on your finances and goals and present you with which options would make the most sense. Get started with a quote from Best Interest Financial in 60 seconds.
FAQ about construction loans and mortgage loans
Are construction loans better than mortgage loans?
Construction loans aren’t objectively “better” or “worse” than mortgages. These loans serve different purposes, and the one that’s better for you depends on your financial situation and what you plan to do with your house.
Do I have to put 20% down on a construction loan?
Many banks require a down payment of at least 20% on a construction loan, unless you’re working with a government-backed loan (less common). If you own the land, lenders may count its equity toward the down payment. Your loan officer can help you know if you’ll need to put 20% down or not.
Is it hard to qualify for a construction loan?
Construction loans can be harder to qualify for than mortgages because lenders have stricter requirements. They tend to be better for people with strong credit, stable incomes, and equity or cash.
FHA construction-to-permanent loans can be easier to qualify for if you’re eligible, but your builder has to be FHA-approved, and there are often build restrictions. Always talk to a loan officer to get a clear idea of what your options are.
How long does construction loan approval take?
It generally takes 30 to 60 days for a construction loan to be approved and closed on.
Why would a construction loan be denied?
Common denials for construction loans include weak borrower finances, incomplete building plans, an unapproved builder, or an appraised future home value below the loan amount.