How do home construction loans work?

The basics of construction loans

Let’s proceed on the assumption that you’re taking out an individual construction loan. Such loansloans, which can be tough to get without a previous banking history because of the lack of collateral (a finished home),
have special guidelines and include monitoring to ensure timely completion so your repayment can begin promptly.

Construction loans are typically short term with a maximum of one year and have variable rates that move up and down with the prime rate. The rates on this type of loan are higher than rates on permanent mortgage loans. To gain approval, the lender will need to see a construction timetable, detailed plans and a realistic budget, sometimes called the “story” behind the loan.

Once approved, the borrower will be put on a bank-draft, or draw, schedule that follows the project’s construction stages and will typically be expected to make only interest payments during construction. As funds are requested, the lender will usually send someone to check on the job’s progress.

Construction-to-permanent arrangement

Upon completion, which is defined by a certificate-of-occupancy issuance and full payment of contractors (and often their signatures on lien releases), the borrower’s loan liability will typically roll over into a mortgage, ideally in an arrangement where the borrower pays closing costs only once. Of late, lenders have been combining the two into a single 30-year loan with one closing, called construction-to-permanent financing. Because of the bank’s greater loan-to-value risks in these, I might add, be prepared to put a little more skin in the game: The lender may offer only 80 percent of project costs or even less. If you already own the land, that can serve as equity.

Construction delays due to weather and material/labor availability are fairly common. Be sure to build some allowances for this into the construction timetable.

They’re a small part of the market

Why is there so little information or competing lender offers on construction loans online? For starters, those loans represent only a very small percentage of home loans. Plus, they’re a bigger risk. Hence, such financing isn’t the type of thing lenders aggressively market online; you have to hit the streets for it. Regional banks and credit unions are typically the best sources.

Without impeccable credit or a strong existing lender relationship, you may be challenged to find an affordable construction loan in today’s lending climate, though a booming local housing market and substantial family income tend to grease approvals.

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