How to finance a custom home build

Key takeaways:

• Building a home requires a different kind of financing than buying one.
• Buyers must choose between two main loan structures.
• Lenders evaluate more than the borrower.

When you buy an existing home, you take out a mortgage. The home serves as collateral, the lender releases the full loan amount at closing and you begin making monthly payments.

Building a home works differently. There is no structure to back the loan on day one. The lender is financing a home that does not exist yet, which means they are taking on more risk. In return, they require more from the borrower: higher credit scores, larger down payments, a licensed builder, detailed plans and a budget that holds up to scrutiny.

Understanding how construction financing works, and how it differs from a traditional mortgage, is one of the first steps in deciding whether building a custom home is the right path.

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• Building a custom home in 10 steps 

A traditional mortgage is a loan to purchase an existing property. The home is the collateral. The full loan amount is disbursed at closing, and the borrower begins repaying principal and interest immediately.

A construction loan finances the building of a new home. Because the collateral does not yet exist, the lender releases funds in stages, called draws, as construction progresses. During the building phase, the borrower typically makes interest-only payments on the amount that has been drawn, not the full loan balance.

Consider a hypothetical example: A buyer is approved for a $500,000 construction loan. After the foundation is poured, the builder draws $100,000. The borrower pays interest only on that $100,000 until the next draw. As the project progresses and more funds are released, the interest payments increase accordingly.

This structure protects the lender by ensuring money is only released as work is completed and inspected.

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• How to buy land for a custom home
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The qualification process for a construction loan is similar to a mortgage in some respects but more demanding in others. Lenders assess credit score, income, employment history, savings and debt-to-income ratio, just as they would for a conventional mortgage. But the thresholds are typically higher.

"Most lenders have a minimum credit rating in the 680 range, a low debt-to-income ratio and income history and cash reserves," said Daniel Cabrera, owner of Roof Direct San Antonio in San Antonio, Texas.

The down payment is also larger. While conventional mortgages on existing homes can require as little as 3% to 5% down, construction loans typically require 20% to 25%.

Cabrera said the preparation matters.

"The first thing to do when you are planning to apply for a construction loan is to organize your financial documents and verify your credit standing before meeting a lender," Cabrera said. "This is important because construction loans are harder to qualify for compared to traditional mortgages."

• Review your credit score and overall credit history. 
• Confirm your debt-to-income ratio is within lender guidelines. 
• Gather proof of income and employment history. 
• Take stock of savings and available cash reserves. 
• Budget for a down payment of 20% to 25%. 
• Plan for potential cost overruns during construction. 

The borrower is only half of the equation. Lenders also evaluate the builder before approving a construction loan. They want to see a track record of completing projects on time and on budget.

"Choosing a builder early in the process is very important, especially when applying for a construction loan," Cabrera said. "This is because most lenders would not approve a construction loan without an approved and licensed builder."

The builder must provide a package of documentation that demonstrates both the plan and their ability to execute it.

"The builder must be able to provide a signed construction contract, a scope of work, a set of plans and specifications, a construction timeline and financial history or references," Cabrera said.

Once the builder's documentation is in order, the lender evaluates the budget and timeline against market benchmarks.

"The lender will order an appraisal based upon the plans and specifications to evaluate the projected value of the completed home," Cabrera said. "They also compare the construction budget to local cost-per-square-foot benchmarks to make sure the numbers are reasonable. If the budget appears inflated or unreasonably low, this also serves as a red flag."

The timeline matters as well. Most construction-phase loan terms are approximately 12 months.

"The lender evaluates the construction schedule to make sure it fits within the loan term, which is generally a 12-month term for the construction phase," Cabrera said. "An organized builder with clean documentation makes the lender's task much easier and more likely to get approved."

If you still need to purchase land, that cost must be included in the overall budget and project plan.

• Hire a licensed and experienced builder early. 
• Confirm the builder's track record and reputation. 
• Obtain a signed construction contract. 
• Secure a detailed scope of work. 
• Provide architectural plans and specifications. 
• Prepare a construction timeline that fits within a 12-month loan term. 
• Create a detailed, line-item construction budget. 
• Ensure budget estimates align with local cost-per-square-foot benchmarks. 
• Include land purchase costs if the land is not yet owned. 

Buyers building a custom home generally choose between two loan structures. Both fund the construction of a new home, but they differ in how the transition to a permanent mortgage works.

A construction-only loan covers the cost of building the home. Once construction is complete, the borrower must refinance into a separate permanent mortgage. This means two closings, two sets of fees and two qualification processes.

The advantage is flexibility. After the home is built, the borrower can shop around for the best mortgage rate and lender. If market rates have dropped during the construction period, this can work in the borrower's favor.

The disadvantage is risk. Mortgage rates are not locked in during construction. If rates rise before the borrower refinances, the permanent loan may be more expensive than anticipated. The borrower must also requalify for the permanent mortgage, which can be a problem if income, credit or employment circumstances have changed during the build.

• Flexibility to shop for the best permanent mortgage rate after construction. 
• Interest-only payments during the building phase. 
• Useful if you expect to sell or refinance quickly after completion. 

• Two loan closings, which means two sets of closing costs. 
• No rate lock during construction, creating exposure to rate increases. 
• Must requalify for the permanent mortgage after the build. 
• Two appraisals and more overall paperwork. 

A construction-to-permanent loan, also called a single-close or one-time-close loan, combines the construction financing and the permanent mortgage into one loan with one closing. Once the home is complete, the loan automatically converts into a permanent 15-year or 30-year mortgage.

This structure is simpler and eliminates the risk of requalifying after construction. Most lenders offer a single interest rate for the entire loan and allow the borrower to lock in the permanent mortgage rate before construction begins.

"Much of the market is dominated by local banks that do an interim construction loan before asking the client to get their own permanent mortgage loan somewhere else," said Brian Hurd, senior vice president at Cardinal Financial Company. "With the single-close construction loan, the buyer qualifies upfront for both loans and closes on them simultaneously."

The qualification process mirrors what a borrower would go through for an FHA, VA, USDA or conventional mortgage, because the permanent loan must meet those program guidelines.

"To qualify you, we must reverse engineer it, so to speak," Hurd said. "We qualify you based on the permanent loan, 30-year fixed, 15-year fixed, and whatever that criterion is. At Cardinal, we do Fannie Mae, Freddie Mac, FHA and VA. So, we're qualifying you based on those criteria and then pairing it up with the interim construction loan."

Hurd said the process is more straightforward than many buyers expect.

"The good thing is that we follow agency guidelines for Fannie, Freddie, FHA and VA," Hurd said. "If you were going to purchase an existing home or a new construction home, the same rules apply."

• One closing, which saves time and reduces closing costs. 
• Rate protection: Lock in the permanent mortgage rate before construction begins. 
• No need to requalify after the build is complete. 
• Predictable long-term budgeting. 

• Less flexibility: You are committed to the same lender and loan terms once the loan converts. 
• Rates may be slightly higher than a construction-only loan to account for the long-term rate lock. 
• More upfront documentation required. 
• Harder to change course or switch lenders mid-build. 

The minimum credit score depends on the type of permanent loan backing the construction financing.

These minimums apply to the permanent loan qualification. Individual lenders may set higher thresholds for construction financing.

With either loan type, the lender does not release the full loan amount at once. Instead, funds are disbursed in phases tied to construction milestones. The lender inspects the work at each stage before releasing the next draw.

1. Pre-construction land draw: Covers the cost of the lot if it has not already been purchased. 
2. First draw (approximately 20%): Site clearing, drainage and foundation work. 
3. Second draw (approximately 20%): Framing for walls and roof, window installation. 
4. Third draw (approximately 20%): Exterior doors, exterior paint, rough-in for plumbing, electrical and HVAC. 
5. Fourth draw (approximately 15%): Trim carpentry, interior and exterior painting, finish plumbing, electrical and flooring. 
6. Final draw (approximately 20%): Occupancy permit, final inspection and loan conversion to permanent mortgage. 

These percentages are approximate and vary by lender and project. The borrower makes interest-only payments on the cumulative amount drawn during the construction phase. If the construction cost exceeds the loan amount, the borrower must cover the gap, typically by depositing additional funds into escrow.

Construction projects carry risks that buying an existing home does not. The lender's stricter requirements exist because of these risks, and borrowers should understand them before committing.

Your financial situation could change. Construction can take six to 12 months or longer. During that time, a job loss, medical expense or other financial disruption could affect your ability to make payments or, with a construction-only loan, your ability to qualify for the permanent mortgage.

"Your house may not be done for six, nine or 12 months," Hurd said. "So, we're assuming that your financial situation is not going to change. That's a risk. People do things they shouldn't do, or sometimes bad things happen to good people. You could lose your job, or whatever the case."

The project could go over budget. Weather delays, labor shortages, material cost increases and design changes during construction can all push costs beyond the original estimate. If the loan does not cover the overage, the borrower must fund the difference out of pocket.

The appraisal could come in low. Before approval, the lender orders an appraisal based on the plans and specifications. This appraisal estimates the home's value once complete. If the appraisal comes in lower than expected after pre-approval, the borrower may owe more than the home is projected to be worth. Options include negotiating with the builder to lower costs, reducing the scope of the project or paying the difference in cash.

1. Assess your financial readiness (credit score, savings, debt-to-income ratio). 
2. Hire a licensed builder and assemble your team. 
3. Develop architectural plans, a detailed budget and a construction timeline. 
4. Get pre-approved by a lender. 
5. Purchase the lot (or include it in the loan if using a single-close product). 
6. Submit builder documentation: contract, scope of work, plans, budget. 
7. Complete the lender-ordered appraisal based on the completed-home projection. 
8. Obtain required permits and approvals from local government. 
9. Close on the loan. 
10. Begin construction; make interest-only payments on drawn funds. 
11. Complete inspections at each draw stage. 
12. Finish construction; obtain occupancy permit. 
13. For construction-only loans: refinance into a permanent mortgage. For single-close loans: the loan automatically converts. 

Related content:

• How to finance building a new home

A construction-to-permanent loan is generally the better fit for buyers who want simplicity, rate certainty and protection from requalification risk. It is the more popular option for first-time builders and buyers who plan to live in the home long-term.

A construction-only loan may be a better fit for buyers who want to keep their options open on permanent financing, expect rates to drop during the build, or plan to sell the property shortly after completion.

In either case, talk to multiple lenders before committing. Not all lenders offer both loan types, and terms, rates and builder approval requirements vary. Ask each lender to provide a full cost comparison, including closing costs, interest rates, draw schedules and any fees specific to their construction loan program.

Related content:

• How to qualify for an FHA loan 
• What is a USDA loan and how does it work?