Construction loans differ from a traditional mortgage in a number of ways, but there are also some similar terms and such that can help you understand the process.

Just as with a standard mortgage for an existing home, you will need to complete a prequalification document so the bank can determine how much money you are able to borrow for land, materials, labor and related expenses. The bank will qualify you for the final mortgage, and at the same time determine if you qualify for construction loan financing. The bank will base your construction loan qualification on several items, such as debt, down payment, cash in the bank, current home equity and credit scores. Banks don't actually create your credit score; they typically request it from the major credit bureaus, including Trans Union, Equifax and Experian. Those scores range from the 700-800's for the very best borrowers, the mid 600's for average credit quality, and into the high 500's for those with a credit history that has several blemishes. Along with the amount of money you have for a down payment, your credit score will help determine the interest rate at which you can borrow money. When you are seeking a construction loan, you will end up with an interest rate for the loan you use to build your house, and an interest rate for your final mortgage, locked in at the time your house is complete.

For instance, your construction loan interest rate may be 8.5% for 12 months, and then convert into a 30-year conventional mortgage at 6.5% interest for your end loan. The higher interest rate on the construction portion of the loan reflects the higher risk the bank has lending you money because the house is not yet completed. Occasionally banks offer adjustable mortgages, or ARMs, that stretch across the construction period as well as a specified number of years after your home is complete.

The interest rate is just one part of the cost of borrowing money, however. All banks charge you for processing your loan, which is typically referred to as "closing costs". These fees can vary widely. One way to understand these costs is by reviewing the APR, or annual percentage rate, of the loan. This number is always higher than the interest rate at which you are borrowing money because it calculates your effective interest rate over the life of the loan, taking into account the fees you paid for the loan.

It's important to understand what's included in your loan. Once you obtain your construction loan and begin building your house, you will need to manage the money the bank has made available to you. Typically, when you close on your construction loan, the bank will provide funds for your land and any immediate material and labor expenses. After that point you will need to submit for a "draw" against your loan. Most banks allow between four and six draws during your construction process, though some may offer far more.