Physical Address
304 North Cardinal St.
Dorchester Center, MA 02124
Construction Loan vs Mortgage: Understanding the Differences
The main difference between a construction loan and a mortgage is that a construction loan is a short-term loan used to finance the building or renovation of a home, with funds disbursed in stages. A mortgage is a long-term loan used to purchase or refinance real estate, with the full amount given upfront. They differ in interest rates, repayment terms, approval process, risk level and term length.
What is a Construction Loan?
A construction loan is a short-term financing option specifically used to build or renovate a home. The funds from a construction loan go towards paying contractors, suppliers, and other costs during the construction phase.
Construction loans provide money in stages as the project progresses, with borrowers only paying interest on the amount disbursed so far. Once construction is complete, the construction loan is typically replaced by permanent financing in the form of a traditional mortgage.
What is a Mortgage?
A mortgage is a loan used to purchase or refinance real estate. With a mortgage, the property being purchased serves as collateral for the loan.
Mortgages are long-term financing options, with repayment terms typically ranging from 10 to 30 years. Borrowers make monthly payments on both the loan principal and interest.
At the end of the repayment term, the mortgage is fully paid off and the borrower owns the property free and clear. Mortgages can be used to purchase an existing home or one newly constructed.
How Does a Construction Loan Work?
A construction loan provides financing in predetermined installments as construction progresses. Before approving funding, the lender performs an extensive review of the building plans and specifications.
The lender disburses money based on completion of certain milestones, such as foundation poured, framing complete, roofing done, etc. An inspector verifies progress at each stage before the lender releases the next draw.
Interest accrues only on the amount disbursed so far. The construction loan rolls into a permanent mortgage once the project is finished, which is used to pay off the construction loan.
What is the Average Construction Loan Term Length?
The average construction loan term is 12 months according to Bankrate. However, the term can range from 6 months up to 24 months depending on the size and complexity of the construction project.
Borrowers only pay interest on the amount disbursed during the construction period. The interest rate is usually variable and tied to an index like the Prime Rate.
How Does a Mortgage Work?
With a mortgage, the homebuyer borrows a lump sum amount to purchase a home upfront. Monthly mortgage payments go towards repaying loan principal and interest.
Down payments are typically required, ranging from 3-20% of the home’s value. The repayment term is much longer than a construction loan, usually between 10-30 years for a conventional mortgage.
Mortgages come in two main types: fixed-rate or adjustable-rate. The interest rate stays the same over the full loan term with a fixed-rate mortgage. Adjustable-rate mortgages have variable interest rates.
Differences Between a Construction Loan and a Mortgage
While construction loans and mortgages are both used to finance real estate, there are some key differences between the two loan products:
1. Purpose of the Loan
The main purpose of a construction loan is to finance building a new home or renovating an existing property. Funds are provided in stages to pay for construction costs.
A mortgage is used to purchase or refinance a home, either existing or newly built. The borrower receives the full loan amount upfront to complete the purchase.
2. Interest Rates
Construction loans typically have variable interest rates tied to a benchmark like Prime Rate. Rates adjust periodically over the loan term.
Mortgages can be fixed-rate or adjustable-rate. Fixed-rate mortgages have an interest rate that remains the same for the full loan term, usually 10-30 years.
3. Repayment Terms
Construction loans are paid back all at once with permanent financing once the project is completed. Borrowers only pay interest on the amount disbursed so far.
With mortgages, borrowers make monthly payments that cover both loan principal and interest over the repayment term of up to 30 years.
4. Approval Process
The approval process for construction loans tends to be more rigorous than for mortgages since lenders have to approve the building plans. Borrowers must have excellent credit.
Mortgage approval is primarily based on the applicants’ finances and credit scores. The property itself just has to appraise for the loan amount.
5. Risk Level
Construction loans are riskier for both lenders and borrowers. Delays or cost overruns put borrowers at risk of default. Unfinished projects are problematic for lenders.
Mortgages are generally lower risk since the home is already built. Appreciation over time also builds equity for the homeowner to buffer against default.
6. Term Length
The typical construction loan term is 6 to 24 months. Permanent financing is required once the project finishes.
Mortgages have much longer terms of 10-30 years. The loan is completely paid off by the end of the term.
Can You Convert a Construction Loan into a Mortgage?
Yes, construction loans are commonly converted into permanent mortgages once the building project is finished. The borrower qualifies for the permanent financing before getting approved for the construction loan.
Some lenders offer one-time close construction loans that automatically convert to a mortgage with no additional paperwork needed. With a stand-alone construction loan, borrowers have to re-apply and close on a mortgage after construction ends.
When Should You Consider Getting a Construction Loan Over a Mortgage?
Construction loans make the most sense when you plan to build a custom home, complete a major renovation, or add an addition like a garage or pool. The staged funding matches when you need to pay contractors.
Since you only pay interest on the disbursed amount, construction loans minimize costs versus having a mortgage sit for months during building. Excellent credit and financials are required to qualify.
When Should You Consider Getting a Mortgage Over a Construction Loan?
Mortgages are preferable when purchasing a newly built spec home, existing home, condo, or townhouse. The home is move-in ready, so no construction is required.
Down payment and credit score requirements are lower for some mortgage programs like FHA loans and VA loans. Mortgages also provide better rate locks than construction loans.
What are the Pros and Cons of Construction Loans and Mortgages?
| Construction Loan | Mortgage | |
|---|---|---|
| Pros | – Only pay interest on disbursed funds – Easier to budget payments – Matches construction timeline | – Lock in interest rates – Lower down payments – Build equity over time |
| Cons | – Variable rates – Short repayment terms – Cost overruns are risky | – Higher upfront costs – Lengthy commitment – Limited flexibility |
Conclusion
Construction loans and mortgages offer two very different financing options for home buyers. Construction loans help fund building a custom home or renovations through periodic disbursements during construction.
Mortgages provide a lump sum for purchasing a move-in ready home. While mortgages offer lower rates and down payments, construction loans better match the building timeline. Understanding the differences can help you choose the best loan for your situation.
