Is a Construction Loan a Mortgage?

You’ll need financing if you decide to build your ideal house or buy an existing house. And what most people get stuck on is whether they need a construction loan or a mortgage and what’s what. Let me make it easier for you.

A construction loan is not a mortgage. It is a short-term loan intended for real estate projects like building a house. The period of a construction loan is one year or less, with higher interest charges. A mortgage is used to buy pre-existing homes, with longer loan terms and lower interest rates. The down payment and repayment requirements also differ between the two.

This article explores the difference between a construction loan and a mortgage, two financing options when it comes to building or buying a house. It looks at the length of the loan, down payment, disbursement of the loan, repayment, and requirements for the loan, as well as differences in interests rates.

Comparing mortgages and construction loans, readers can identify which of the two options best suits their needs.

What Distinguishes a Construction Loan From a Mortgage?

Are you interested in building or renovating your home but unsure of the distinction between a construction loan and a mortgage? If yes, you’re not alone. The contrasts between a construction loan and a mortgage roll the heads of a lot of people.  

A construction loan is, in general, used to build new homes, whereas a mortgage is used to buy pre-existing homes. Making an informed decision that will benefit you in the future is a must. 

Here you will find all the necessary information to tell apart construction loans and mortgages and which one fits you:

Length of Loan Term

Compared to traditional mortgages, construction loans have substantially shorter terms. A 30-year loan may be the most typical option. Yet, homebuyers do have the choice to choose shorter terms, such as 20 or 15 years, depending on their bank. 

The period of a construction loan is one year or less. The interest charges are higher as well. When your construction loan application is accepted, you may begin using the funds for each stage of construction. You can repay the funds by the time the construction is completed.

When you take out a mortgage, your home serves as collateral. If you fall behind on your payments, the lender may seize it. With a construction loan, a house is not needed as collateral. This makes construction loans way safer.

Down Payment

The amount of a down payment needed for a mortgage varies depending on the type of loan selected. It’s common to hear that mortgage down payments range from 5 to 30%, depending on the lender and type of loan.   

Similar to mortgage loans, different construction loans have different down payment requirements. However, their standards do tend to be higher. A 20% down payment is required by lenders, but others could ask for 30% or even more. 

Disbursement of Loan

Your lender pays the homeowner a one-time lump sum when you take out a mortgage. But when you get a construction loan, your lender gives you payments as your builder completes various stages of your house. 

Applicants might need to submit paperwork like schedules and blueprints. It’s done before the construction loan is authorized. 

Withdrawals normally take place after an inspector or assessor inspects the work of your builder. The builder receives the funds after approval. And the subsequent phase of the process starts. 

Repayment

Each monthly payment you make toward your mortgage includes:

1. principal
2. interest
3. property taxes
4. homeowner’s insurance

Even a homeowner’s association fee can be integrated. It depends on where they live. For the mortgage loan to be fully repaid, the borrower usually has to make regular monthly payments. These payments are made for a certain duration of time, usually 15 to 25 years. 

In contrast, you only have to make interest payments on a construction loan while the building is being done. When the time is up, you can pay down the remaining balance in one lump sum. When you apply, the lender and your credit history determine your repayment options. So, be sure to examine several loans, terms, and repayment features before making a decision.

What Are the Requirements for a Construction Loan?

Construction loan lenders have standards that borrowers must follow to be eligible for the loan. It’s similar in the case of a regular mortgage. The following are major requirements demanded by most construction loan lenders:

• Credit score: To be eligible for a construction loan, most lenders will set a credit score requirement of 620 or higher.
• DTI (debt-to-income) ratio: Your DTI is calculated using your total monthly expenditure and your monthly income. 
• Down payment: When applying for a construction loan, you’ll probably need to come up with a 20% to 30% down payment.
• Choice of builder: Your lender will want to approve the builder who will be constructing your new house. And also through your builder’s history to check their license and insurance.
• Construction plan: Your lender will need to permit your construction plan. In general, it is ideal if you can give your lender as much information as you can.

Before you sign any paperwork, be sure you understand the terms and requirements of the loan.

Why Do Interest Rates Differ Among Construction Loans and Mortgages?

The interest rates for loans and mortgages are influenced by a variety of factors. They are based on your credit score along with your other information, such as your debt-to-income ratio. 

Generally, it’s considered a risk to give out a construction loan by the lender. Why? Mainly because the project hasn’t yet been finished.  

The increased risk involved in financing construction loans often carries higher interest rates. Besides, construction loans have a shorter loan period than a mortgage. It may also impact the interest rate.  

Some lenders may provide construction loans with lower interest. However,  it’s crucial to compare lenders to find the best and safest deal.

Final Thoughts

As you can see, both mortgages and construction loans have their uses and are excellent. But they are not quite the same. Construction loans imply shorter terms but higher interest rates. Whereas mortgages come in as one big sum, which is then paid off over a longer period.

Usually, you’ll want a construction loan if you’re renovating or building from scratch. But if you wish to buy a pre-existing home, a mortgage is what you will need.

 Of course, to decide which to use, you must have a good understanding of your needs.