How Does Construction Financing Work When Building a New Custom Home?

Published April 19, 2024

Construction financing for a custom home is a specialized type of loan designed to provide funds over the course of a home construction project, rather than as a lump sum like a typical mortgage. Below is an overview of how the new-build home construction financing process typically works.


Before you begin construction, or sometimes even before purchasing a lot, it’s a good idea to meet with a lender to get pre-approved. This will help you understand how much you can borrow and what the terms might look like.

Loan Types

Construction-only loan: This is a short-term loan, typically for about a year, that covers only the cost of building your home. Once construction is complete, you must refinance the loan into a traditional mortgage or pay it off in another manner.

Construction-to-permanent loan: Also known as a “one-time close” loan, this loan covers the construction period and then converts into a standard mortgage once the home is finished. This means you only have one set of closing costs.

Down Payment

Construction loans for custom homes typically requires a larger down payment than traditional mortgages. It’s common for lenders to require 20-25% down, though this can vary.

Interest Rates

The interest rates for new-build home construction loans can be variable or fixed, but they’re generally higher than traditional mortgage rates.

Draw Schedule

Unlike traditional loans that provide a lump sum when purchasing an existing home, custom home construction loans release funds in “draws” or installments. As the home is being built and reaches certain predefined milestones (like foundation completion, framing, etc.), the builder will request draws from the loan to pay for the work done up to that point. The lender will often send out an inspector to confirms that the milestones have been reached before releasing the funds.

Interest-Only Payments

During the construction phase, you’re typically only required to pay interest on the amount drawn. This can help keep costs lower during your new home’s construction, but it means you’re not building equity in the home during this time.

End of Construction

For construction-only loans, you’ll need to secure a traditional mortgage to pay off the construction loan or find another means of paying it off. For construction-to-permanent loans, the loan will automatically convert into a regular mortgage, and you’ll start making standard principal and interest payments.

Contingency Reserves

Lenders for new home-build loans often require a contingency reserve of 5-10% of the loan amount to cover unexpected costs that might arise during construction. If the reserve isn’t used, it can go towards the mortgage or be returned to the borrower.

Appraisals & Loan-to-Value

Lenders will often require an appraisal of the future value of the custom home (what the home is expected to be worth once it’s completed). This future value will impact the loan-to-value ratio and how much the lender is willing to lend.

Builder Selection

Many lenders have a list of approved builders. If your chosen builder isn’t on that list, they might need to undergo a vetting process. The builder’s experience, financial stability, and reputation can impact loan approval.

Insurance and Inspections

Builders risk insurance is typically required to protects against damages during the construction of your custom home. Also, regular inspections might be required to ensure building codes are being met and the project is progressing as planned.

If you’re considering building a custom home, it’s important to work with experienced professionals, including a knowledgeable lender, builder, and possibly a financial advisor. This will ensure that you understand all the costs involved, the risks, and the timeline, and that you’re getting a loan product that aligns with your financial situation and goals. Contact LaFollette Homes to get started building your dream home today.



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