There are two types of construction loans available a construction-to-permanent loan and construction-only loans. Here’s how they work:
1.) CONSTRUCTION-TO-PERMANENT
This type of loan (also known as “single-close” construction loans) covers the costs of construction on your future home, in phases, while it’s being built. Construction loans terms are short-term (generally a 1-year maximum).
The lender who approves you will pay your builder in installments during each phase of your construction process. These payments are called “draws.”
For example, if it takes $50,000 to complete the first phase of building your home, your payment will be toward that $50,000, and not the entire purchase price of your project.
The lender will usually perform progress inspections as funds are requested throughout the construction phases: for example, pouring foundation, beginning framing, installing plumbing, and so on until your dream home is completely built.
Once your home is finished, and you move in, the construction-to-permanent loan rolls over into what will be the borrower’s mortgage. This allows you to only pay closing costs once.
2.) CONSTRUCTION-ONLY
A construction-only loan covers the construction of your home, in full, up front. The borrower pays the closing costs. When construction is finalized, the construction debt becomes your mortgage, which is considered a second loan, for which you pay closing costs a second time.
Construction-only loans are best for borrowers who have large cash reserves, or who want to shop permanent lender options while their home is being built. It’s also an option for people who will live in their current home while their new home is being built.