Construction Loans in California — Building House Requires Financing

If you can’t find the right home to buy, there is always an exciting opportunity to build a new house and personalize it to your taste and lifestyle needs. But just like purchasing a house, building from the ground-up can be an expensive prospect.

Luckily, a custom home construction loan provides the funds needed to build a new house, including payment for raw land, plans and permits, material and labor, and closing costs — basically, any legitimate expense associated with the construction project. In an article “Construction Loans: What They Are and How They Work” for Credible, Amy Frontinelle states that the process of borrowing money to finance a custom home built differs from a traditional mortgage in terms of how funds are distributed and how the loan is structured. Custom home construction loans have higher interest rates and are secured by the property they finance.

what exactly is a construction loan?

Custom home financing is a loan granted for the purpose of building your dream home and other real estate properties. Such loans come with unique characteristics and are usually a form of short-term financing — typically a period of no longer than one year. To obtain a construction loan, you will need to provide the lender with a building timeline, detailed plans, and a realistic budget.

That said, the borrower isn’t given the total approved lump sum right away. You can only access funds in a series of advances called "draws" according to a prearranged schedule or milestone: such as pouring the foundation, framing out the building, and substantial completion of the home. As a result, an appointed appraiser or 3rd-party inspector is required to check and confirm that a particular phase has been completed before the lender approves the draw request — and, similar to a line of credit, interest payment is based only on the actual amount borrowed to complete each portion of a project, as noted in the inspection report.

Construction-to-permanent loan.

Also referred to as CP loan, construction-to-permanent loan converts short-term custom home financing for buying land and building a home into a more traditional type of loan, such as a permanent mortgage, once the property is complete. With a traditional mortgage, typically a loan term of 15 to 30 years, you make payments that cover both interest and the principal.

Erik J. Martin writes in his article “Building a Home from Scratch with a Construction-to-Permanent Loan” for Next Advisor that with this construction loan “you don’t have to apply, qualify, complete paperwork, or pay closing costs for two different loans” — which, ultimately, “saves you time as well as money otherwise spent on separate application and settlement fees.”

Construction-only loan.

Also known as "two-close" construction loan, it provides the projected necessary amount of money needed to cover the actual construction of a home. During the construction phase, the borrower is only responsible for interest payments on the funds drawn. Once the custom home is complete, the construction loan must be paid in full or refinanced into a separate mortgage loan. A construction-only loan can ultimately be costlier as it requires two separate loan transactions: two application processes and two closings.

Owner-builder loan. This is either a construction-to-permanent or construction-only loan where draws are made to a borrower who can demonstrate experience as a general contractor — or have a contractor’s license. This type of loan generally requires the homeowner to have in-depth understanding of the complexity of constructing a home, the experience required to comply with building codes, as well as the expertise to oversee construction.

Renovation loan.

A renovation loan gives homeowners access to funds necessary to make any major structural and aesthetic change. The loan amount is therefore based on the homes’ predicted value after renovation. With these types of construction loans, you might consider one if you don’t need a whole mortgage but just enough cash for a home overhaul or a home addition. The funds granted may cover costs such as installing or updating heating and cooling systems, energy improvements, mold remediation, or renovating the kitchen and bathroom to add more value to your home.

Construction loan requirements

In general, construction loans are riskier for lenders because the loan won’t be secured — meaning there’s no collateral to back it up. For this reason, the process of being approved to break ground on a brand-new home in California can be more rigorous than traditional mortgage loans. The criteria you’ll want to meet to win approval including:

Credit score: as is typical with any type of loan, homeowners need good to excellent credit to win approval for custom home financing. Credit score required to undertake a construction project is 620 or higher. And for many, this is just the minimum, as some lenders may require a score of 720 or better. To improve your credit score, focus on reducing debt and paying bills on time in order to get the best rate when applying for a new custom home loan.

Down payment: a down payment is required and varies by lender and the amount you’re trying to borrow to pay for your construction project. Some lenders will ask for a down payment for as little as 10% while many lenders require at least 20% - 25% of the total construction costs.

Debt-to-income ratio: a debt-to-income (DTI) ratio compares all of your monthly obligations to your gross monthly income. Lenders typically require 45% or lower when issuing construction loans. A higher ratio may be possible if the borrower has strong finances.

Repayment plan: to determine whether they will finance a project, lenders thoroughly examine the ability of the borrower to repay the loan. In most cases, construction loans usually require the homeowner to set aside a certain amount of money called an interest reserve, where monthly payments are made based on the amount drawn during the construction period.

Builder or general contractor approval: likewise, to get approval for a construction loan, you will need to engage an architect and builder that’s qualified, licensed, insured, and has a credible work history and a solid record of finished projects (within set budget and time frame). The lender may require submission of the architect, general contractor, and builder’s insurance certificate copy, resume, proof of financial stability, and a description of each party’s responsibilities.

Construction loan process  

If you require home construction financing, the typical house building loan process involves the following:

Compare loan structures from several lenders.

To get started with your new construction home loan process, it’s important to do a thorough research of different experienced construction loan lenders and obtain multiple rate quotes. This allows you to compare interest rates, loan procedures, repayment terms, and down payment requirements for each offer, to ensure you’re getting the best possible deal for your situation.

Get preapproved for custom home loan.

This step provides the homeowner an understanding of how much they are able to borrow looking at details such as your income and credit score. Aiming to get preapproved before approaching a custom home builder helps you avoid drawing up blueprints for a home that you will not be able to afford. Upon receiving preapproval, the lender will provide the borrower a letter with an expiration date (most preapprovals are good for 60 to 90 days).

Find a licensed custom home builder.

The third step for a new construction home loan process is to find a licensed and reputable custom home builder in California. Just as you would compare multiple homes on the market before making a purchase, it’s equally important to compare offers from licensed builders based on price and expertise that fit your needs. In our post “Choosing A Builder for Your Home in California” we discuss the important steps you can take in order to choose an ideal custom home builder for your residential project.

It’s also crucial for you as a homeowner to draw up a construction work plan and time frame with a prospect contractor, as the final draw directly depends on the amount of building work to be performed by the design-build firm.

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Get approved for a construction loan.

After gathering estimates, drawing up a construction work plan, signing a construction contract with your builder, and obtaining any necessary proof of their business credentials, it’s time to proceed with getting approved for a construction loan. The approval process involves evaluation of your income, financial statements, debt and credit history to determine the amount you can be financed with.

Terms for new home construction loans


Financing for a construction project is inherently considered to be riskier for lenders than a standard purchase money loan to buy an existing home. For the most part, construction projects are full of unknown variables and lenders have a history of not seeing returns on their loans.

But with the expansion of California’s housing market, there is an increased demand for new residential properties — and in turn, a higher volume of new custom home loans. Whether it’s the homeowners first or second property, lenders prefer that construction loans be used for the intend to build and live in the home rather than sell it.

Down Payment/LTV

Most lenders who offer best home loans available want to see a substantial down payment upfront. This means the homeowner needs to start the construction process with their own funds before a lender agrees to loan more. High down payments are usually the lenders way to ensure that you’re fully invested in the project.

The Loan-to-Value (LTV) ratio is the relative difference between the loan amount and the current market value of a home, and it helps determine how much money the lender can fund and at what interest rate. 75%–80% loan-to-value (LTV) ratio for construction loans means 20%–25% down payment.

Loan Length

Most new home construction loans provide short-term funds designed to be paid off as soon as the residential property has been completed. This construction process usually last 6 to 12 months. As mentioned above, the loan may be followed by a conversion into a long-term traditional mortgage, typically a single-closing loan term of 15 to 30 years — most lenders expect the first-phase construction loan piece be paid off in about 12 months (but sometimes it may be extended because of unavoidable construction delays).

Amortization & Payments

During the construction phase, you typically make interest-only payments (not principal) based on a series of installments or draws for each completed milestone. After the house has been completed, construction-to-permanent loan will be amortized much like the traditional mortgage, where monthly payments of both principal and interest must be paid.

Interest Rates

There are many lenders in California that can finance your dream home project, but these construction loans are often attached to higher interest rates. Generally, short-term loans can have either a fixed or variable interest rate during the construction phase. Variable will carry “prime-plus” interest rate; therefore, it’s important to understand the range within which your interest rate can fall.

Collateral, Underwriting & Processing

Once all documentation has been submitted for a construction loan approval, the information is sent to a credit analyst for underwriting before a decision can be made. Because the lender relies mostly on the strength of the blueprint, construction timeline, and the reputation of your building contractor, the approval process can be lengthy and a lot tougher than traditional mortgages, where your home is the collateral.

Collateral is what the lender can seize in the event that you fail to repay the loan according to the terms which have been agreed. If the borrower has another asset such as land already owned, the land itself can be used for the collateral. During the construction of your new home, processing activities such as tracking draw requests, progress inspections, mechanics’ lien waivers are to be expected until the residential property is completed.

Pros and cons of a construction loan

While new custom residential financing offers you the opportunity to kick start your new real estate project, it’s important to understand all the pros and cons of construction loans before placing your signature on the contract. Here are some of its advantages:

Interest-only during construction

Most lenders will not ask you to repay the full loan amount during the construction of the project, only the interest on the withdrawn amount. This can be extremely useful as it gives the homeowner a lower monthly obligation and more time to save up.

Terms are flexible

Although lenders will require submission of detailed plans for your project, construction loans are much more flexible and tailored quickly and effectively to your project’s specifications.

Phased check-ins keep things on-track

With a construction loan, you can expect a lender representative to show up at your worksite before they release the next round of funds to you — this can help keep things on truck and get the job done according to schedule and a set budget.

No financial product is ever perfect so there are a few potential drawbacks to be expected with construction loans including:

Higher interest rates

Because it is a riskier investment that requires short-term funding, construction loans normally have variable interest rates that correspond to prime rate percentage — which can mean a wide range of possible increases and decreases from the initial rate.

Required credit scores and down payments are often higher

Construction loans are pretty flexible — for this reason, lenders impose higher qualifying standards in terms of credit scores and down payment.

Shorter terms are risky

Remember that at the end of the loan term, the lender will expect a full payment of the loan. If you’re considering this route, be sure to have a way to pay off the loan.

Credit score changes

Should the credit ratings drop between the time you’re approved and the end of the construction period, the lender could deny converting your construction loan into a conventional mortgage. And if you don’t have the cash to pay off the loan balance in full, your new custom property could end up in foreclosure.

Frequently Asked Questions

What does a construction loan cover?

Construction loans cover costs such as raw land, architectural plans, design fees, contractor labor, building materials, permits, and any legitimate expense associated with a construction project.

How do construction loans work?

Unlike conventional home purchase loans, construction loans are designed to release funds in a series of advances called "draws" at each stage of the build. This short-term loan typically last for only the length of 12 months on average. The draw schedule allows the custom home builder to cover costs for each phase. These loans also require the homeowner to work with an experienced builder that is financially sound, licensed, and insured.

What are construction loan rates in California?

Construction loan interest rates vary based on the borrower’s credit worthiness, the size of the loan and the loan term. What’s more, having a strong borrower profile (such as enough income to pay off the loan, money for down payment, an excellent credit score and debt-to-income ratio) will help you qualify for the best possible rate.

What are construction loan types?

These are construction loans available to homeowners looking to undertake a building project. They include construction-to-permanent loan, construction-only loan, owner-builder loan, and renovation loan.

How to apply for construction loan in California?

Like with any home loans, you’ll need to meet a certain set of requirements in order to apply for a construction loan in California. To have a better understanding on the different types of loans and the approval process, a thorough research is necessary.

How to choose a construction loan lender?

The first thing to consider is the lenders’ expertise with construction loans, the types they offer, and the interest rates available. Best of all, opt for a lender who has gone through the homebuilding experience numerous times and has a strong sense of what can go wrong and how to avoid problems.

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