Here's what you should know about construction loans before applying for one

When financing the purchase of a home already on the market, you can depend on a mortgage to help with the costs. But what happens when you need to pay for a home that only exists in your dreams? That's where construction loans come in. Below, CNBC Select breaks down what you need to know about getting a construction loan.

A construction loan only covers the cost of building a new home. This includes land purchases, contractor labor, materials and any permit fees. With a construction loan, the home must be completely built and have a certificate of occupancy issued on the property within one year, making it a short-term loan. Mortgages, by contrast, are long-term loans since the term length can last anywhere from 10 to 30 years.

When you apply for a construction loan, you'll typically have to submit the appropriate financial documentation that you would for any other loan, plus a project proposal for the build that outlines the phases of the project, as well as timelines for completion of each phase.

Once approved, the borrower can begin using small amounts of the loan funds to initiate the build. An appraiser or inspector will also be on-site at certain benchmarks during the project to assess the progress and authorize the borrower to continue using the loan funding.

Once the build is complete, the borrower must then either pay back the loan or convert it into a mortgage.

Keep in mind that construction loans can be riskier for lenders compared to traditional home loans since you don't have an existing home to use as collateral. Because of this, construction loans may carry higher interest rates.

For the most part, you'll be required to only pay interest on your construction loan until the build is complete.

Before you apply for a construction loan, you should already have the plans for your build and contractors ready to execute your vision. Once that's settled, you'll want to research lenders and submit applications. Keep in mind that not every mortgage lender offers construction loans. Flagstar Bank, however, offers not only both mortgages and construction loans but a wide selection of other loan types as well. Terms for this lender range from 8–30 years.

If you don't plan to convert your construction loan into a mortgage, you can either pay off the principal out of pocket or take on a separate mortgage to cover the principal over time. You'll want to look for as many ways possible to save money if taking out a separate mortgage, which is why Ally Bank deserves your consideration. Ally doesn't charge lender fees, which can significantly increase the cost of getting a home loan.

To improve your chances of getting approved for your desired home loan, you'll want to take a few steps to get financially prepared for the event. Make sure your credit score is in a healthy range and do what you can to improve it. Lenders will use your credit score to determine the interest rates you'll qualify for when applying for your home loan.

Interest rates can make borrowing money even more expensive. The higher the rate, the more costly it will be to take on that mortgage. This can cost you tens of thousands of dollars over the life of the loan.

You'll also want to make sure you have an emergency fund on hand since surprise expenses are bound to pop up during the home buying (and the home building) process.

Just like mortgages, construction loans come in a variety of types that can help borrowers reach their financial goals. Here are a few of the most common ones you should learn about.

Construction-to-permanent loan

With a construction-to-permanent loan option, your construction loan gets rolled into a traditional mortgage once your build is complete. Lenders typically only require you to pay the interest on a construction loan while you're still in the process of building the home; you'll still owe the principal after construction is complete.

The principal is what gets rolled into the traditional mortgage and from there, you'll make your monthly mortgage payments.

Because this option turns the construction loan principal into a mortgage, you'll only apply for one loan and pay one set of closing costs.

Not all lenders offer a construction-to-permanent loan option so you'll want to double-check with your desired lenders before submitting an application. TD Bank is one solid contender that does offer this option. Plus, their loan can be used for primary residences of 1 to 4 units and for second or vacation homes.

Construction-only loan

The construction-only loan option is fairly self-explanatory; the borrower takes on a construction loan that doesn't convert into a regular mortgage upon completion of the build.

With this option, you'll pay the interest during the construction period but once it's over, you'll have to pay the principal back in one lump sum.

This option avoids any complexities of rolling your construction loan into a mortgage, however, you'll typically need to have a lot of money on hand to pay off the construction loan principal. Because of that, this may not be the best option for someone who's low on savings.

Alternatively, you may apply for a separate mortgage to pay off the construction loan principal, but this means you'll have to submit two separate applications and pay for two sets of closing costs, which can make this option very costly.

End loan

Remember how we said that if you take on a construction-only loan you could choose to apply for a separate mortgage to pay off the principal? That separate mortgage is what's known as the end loan.

Again, you'll have to submit two separate applications and pay for more than one set of closing costs, which can run you more money compared to doing a construction-to-permanent loan. Typically, a borrower would only choose to take out an end loan if they want to work with a specific lender that doesn't offer a construction-to-permanent loan.

Owner-builder loan

With this type of loan, rather than using the funds to pay contractors to perform the work for you, you as the borrower build the house yourself. As you might suspect, you need to be a licensed contractor to qualify for this type of loan.

Renovation loan

A renovation loan isn't really meant for building new construction; it's actually meant for borrowers who are buying a home that needs major changes — like expanding the kitchen or adding a bathroom.

With this type of loan, the costs for the renovation get rolled into the mortgage so you only apply for one loan and pay one set of closing costs.

Construction loans can be a handy way to finally become the owner of your dream home, but you have to think long and hard about the best way to manage the loan's principal. Talk with different potential lenders and make sure you completely understand what you're taking on before signing anything.

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