When building your dream home, you will likely get a construction loan instead of getting a traditional mortgage. A construction loan is a shorter-term, higher-interest loan used to cover the cost of rehabilitating or building your home. The three different types of construction loans include:

Construction-only loans: These loans have to be paid in full once construction is over. It is ideal if you have large amounts of cash to work with, or you are sure the money from the sale of your home can cover another build. Construction-to-permanent loans: If you have a definite construction plan with a timeline in place, consider this type of loan. Once the construction is completed, the bank pays the builders, and the loan rolls over to a mortgage. Renovation construction loan: If you are buying a house that will require repair, consider using this loan.

How Construction Loans Work

A construction loan is paid out in installments, unlike the traditional mortgage loan, where you get a lump sum to cover your home’s cost. A builder receives payments from the bank in stages, as different phases are completed. Once the construction is finished, the total cost is transferred to you. The installments are referred to as draws. Since draws are reimbursed after a phase is completed, either you or the builder should have enough cash upfront to cover those costs.

Benefits of a Construction Loan

They have flexible terms: Despite you being required by the bank to provide your plans for the project, construction loans are flexible with their guidelines and terms compared to traditional loans. You can work your loan terms according to your project needs.
Pay the interest during construction: You are only required to pay interest while constructing the house. Once the construction is done is when the bank asks you to start paying the principal.
The added scrutiny gives you structure, helping you stay on schedule and a budget.

Disadvantages of a Construction Loan

They are harder to qualify for since they are very flexible
The interest rate is high, with lenders adding a certain percentage over the prime rate.
They are risky, especially if you choose construction-only loans. The lender expects full payment at the end of the loan term.

Construction projects are expensive, and to make it work, you need money. If you are looking for funds for your construction project, consider Diamond Capital Financing, where you can get capital to cover all the construction-related expenses.