Construction Loan vs. Mortgage: What’s the Difference?

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A mortgage loan is used to purchase a home, but it cannot be used to finance the construction of a new home. Builders and borrowers who would like to finance the building of a new home could apply for a general loan, or they could seek out a special type of financing called a construction loan.

As the name implies, a construction loan is generally used only during the construction of a home or building. Once the home is built, the borrower typically must pay off the construction loan. Mortgage loans are only available for homes that are already built and livable.

This chart shows the basic differences between construction loans and mortgage loans.

Construction loans

When comparing a construction loan vs. a mortgage loan, one of the biggest differences tends to be that construction loans are not secured by a completed house. Mortgage loans, on the other hand, are often secured by the home being purchased.

Construction loans by design are short-term, as they are meant to last only as long as it takes for the construction project to be completed. As construction progresses, funds from the construction loan are typically released in a series of disbursements. The disbursement of funds may also differ across lenders, so be sure to thoroughly research your options before deciding where to get your financing.

When the home’s construction is complete, the borrower may pay off the balance of the construction loan with a lump sum or, in some cases, convert it to a conventional mortgage loan.

More rigorous approval process

The approval process for a construction loan can be more rigorous than with a conventional mortgage loan. For both types of loans, a lender will likely consider factors like the borrower’s credit score, debt-to-income (DTI) ratio, and down payment.

For a construction loan, lenders may also want to approve the builder who will be constructing the home and the construction plans, including blueprints, budget, and builder payment schedule.

Short-term

Repayment terms for construction loans tend to be much shorter than mortgage loan repayment terms. That’s because the construction loan only lasts throughout the building of the house — typically 12 to 24 months. A mortgage loan, on the other hand, is a long-term financing vehicle, with repayment terms usually from 15 to 30 years.

Higher interest rates or down payments

Construction financing may be more expensive than a mortgage loan because lenders might classify this type of financing as riskier, given they may not have a finished product to serve as collateral for the funds. A construction loan may require higher interest rates and larger down payments to lessen that risk.

Disbursed in phases

With a construction loan, the lender typically disburses funds at the completion of each phase of construction or as additional funds are needed. The borrower’s interest payments only cover interest on the amount that has been disbursed, much like the interest payments on a line of credit.

The disbursement schedule is different with a mortgage. In that case, all the money from the loan is paid out upfront, covering the entire cost of the home at once. The borrower will then pay back the principal, interest, and any additional fees agreed upon over the set repayment period the lender has provided.

Traditional mortgage loans

Traditional mortgage loans are a form of secured financing because they are secured by the tangible asset, the home that they will finance.

Mortgages are long-term loans and are only available to finance homes that are already constructed. Borrowers who finance the building of a new home with a construction loan may take out a mortgage loan when the construction on their home is finished or convert the construction loan to a more traditional mortgage loan.

Easier application process

A mortgage loan may require a less complicated application process compared to a construction loan. That’s because a construction loan requires borrowers to submit detailed information about the planned construction, such as house plans, builder contract, project budget, and draw schedule.

Long-term repayment

Mortgages typically offer a long-term repayment of 15 to 30 years. Construction loans are short-term loans, with a repayment term of 12 to 24 months in many cases. That’s because construction loans must be repaid when the home construction is complete, but mortgages finance a completed house over the long term.

Consumer protections

The federal government affects the traditional mortgage market through the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac). The Federal Reserve also influences current mortgage rates by setting the federal funds rate.

There is no standardized government involvement with construction loans.

Financing new construction projects

For anyone looking to finance a new construction project, a construction loan rather than a traditional mortgage may be preferred. Because a construction loan often requires interest-only payments until the project is complete, it may prove helpful for managing construction business cash flow.

Business owners and aspiring homeowners may also be able to use personal or business loans that are not industry-specific to fund building a new home or facility, so long as the loan agreement they sign with their lender allows for the funds to be used in that way.

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