Why Financing the Construction of a New Home Could Involve More Than One Loan

To pay for new construction, you’ll probably want to get three separate types of financing: land financing, construction financing, and permanent financing.

By , Attorney Yale Law School
Updated 12/11/2023

When putting together financing to build a new home, you'll likely need a different set of loans than if you were buying an existing home. With an existing home, many homebuyers simply get a first mortgage to cover most of the purchase price. But with new construction, your financing requirements—like the construction project itself!—will be a little more complicated.

You'll probably want to obtain three separate types of financing: land financing, construction financing, and permanent financing. Fortunately, you won't necessarily need to approach three separate lenders. Because land financing flows into construction financing and construction financing rolls into permanent financing, one lending institution should ideally be able to provide all of them.

Getting Land Financing for the Property Purchase

You can't build a new home unless you've got some vacant land on which to build it. A bank that will be providing construction financing will typically want the borrower to have the land in hand before it commits time and resources to the construction-loan application process.

Some people simply buy the land outright, out of savings or with help from friends or relatives—help that sometimes takes the form of a short-term loan secured by the land.

More often, people get short-term financing from a bank—often the bank that will (assuming the subsequent application process goes well) be providing the construction financing. The term of the loan can be as short as the time it takes the bank to process your application for a construction loan. The loan will be interest-only until it is folded into your construction financing.

Having excellent credit and architectural plans in hand will make it more likely that you'll be succeed in getting both your land financing and your construction financing from the same lending institution, and at a lower cost than you'd be offered if working with two different lenders.

Getting Construction Financing

The amount of construction financing a lender will offer someone building a home is normally calculated as a percentage (usually 80%) of the cost of building. The bank will determine these building costs based on the architectural plans. You can put up the remainder—the deposit—in cash, but most people use the land they intend to build on to meet the bank's deposit requirements.

If there's any existing financing secured by the land, the bank will roll the outstanding balance into the construction financing. The loan will be "interest-only" during the construction period but, as the outstanding principal balance increases with the amount of the contractors' draw downs, the amount of interest payable periodically will increase until the permanent financing (described next) is in place.

Getting Permanent Financing for Your New Home

When construction is completed, you can roll your construction financing into what's known as permanent financing. Permanent financing is just like a mortgage loan you'd get from a bank if you were buying an existing house. Most permanent mortgage loans have a fixed rate and are payable in equal installments of principal and interest for a fixed term, like 20 or 30 years.

The bank might also finance a percentage of construction cost overruns, interest paid during construction, or out-of-pockets for project-related costs, like engineering and architectural fees, if the total doesn't exceed a predetermined percentage (often 80%) of the value of the completed construction project.

You're not bound to use the same bank for the permanent financing that you've worked with up to now—but it's less expensive to do so. You've got an existing working relationship and the bank probably won't charge additional attorney fees and other closing costs.

Expect the application process for permanent financing to be essentially the same as if you were buying an existing home. After you've provided one set of the required documentation, like credit information, and paid the required fees, follow-up application processes with your lender should be quick and uneventful.

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