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How Do Construction Loans Work?

Construction loans are different from home mortgages. A standard home mortgage uses the house and land as collateral against default on the loan. If you cannot or do not repay the mortgage as prescribed by the mortgage agreement, the lender can take the home to satisfy the mortgage balance. Construction loans are usually unsecured, which means the lender is taking a bigger risk because there are no assets for them to sell to repay the loan.

Another difference with construction loans is that they are not paid out all at once. They are paid out in portions, usually four equal payments or "draws", as work progresses on the home's construction. At the point where the first 25% of the construction is complete, the lender will issue the first payment, equal to 25% of the total loan amount. In order for the payment to be made, an appraisal must be done to assure the lender that satisfactory progress has been made. Additionally, paperwork must be provided to the lender to document the expenditures made for materials and labor. Three additional payments (or whatever number is set forth in the contract) will be made as the construction milestones are reached. The payments can be made directly to the builder or to the homeowner if they have already paid the builder.

Construction loans are usually interest only loans and the payments are calculated on only the amount of money that has been funded. So on a $100,000 loan, after the first disbursement of 25% of the total loan, the payment would calculated using $25,000. After the second disbursement the payment would be based upon $50,000 and so on. Once the construction is complete and the final disbursement has been made, the loan becomes due in full. At this point a standard mortgage is typically taken out on the home to pay off the construction loan. In virtually all cases, this mortgage was arranged before or simultaneously with the construction loan.

How Do I Get a Construction Loan?

The first step to getting a construction loan is to find a lender who does construction financing, because not all lenders offer this product. There are a couple types of construction loans. One type of financing requires applying for and closing two distinct loans, the construction loan and the home mortgage. The other option is a "construction to permanent" also called a "combination loan" in which the loan changes automatically from a construction loan to a standard mortgage upon completion of the home.

Generally, the combination type financing is more convenient and may yield big savings in loan costs. Some lenders offer a rate lock, which can be advantageous if you believe interest rates will go up before your home construction is complete. On the other hand, you can let the rate float if you expect interest rates to decline during construction.

If you obtain two loans, you will need a commitment letter from the mortgage lender guaranteeing to fund when the home is completed. The mortgage funding pays off the construction loan, which becomes due when the "certificate of occupancy" has been issued. This letter is needed before you apply for construction financing as lenders won't consider your loan without it.

Regardless of which style of financing you use, there will be deadline dates to meet. Most importantly is the completion date. If the home is not issued the certificate of occupancy before the deadline expires, the mortgage guarantee and/or any rate lock agreements may expire. Therefore it is very important to build construction delays into your time line; rarely do large construction projects finish on schedule.

When the construction loan lender considers your application, they will also evaluate your builder. The lender takes a larger risk on construction loans than they do on most other types of loans. The lender wants to minimize the risks by ensuring the builder's financial condition and reputation indicate they are qualified and able to build a quality home. The lender will also review the design plans to evaluate the anticipated cost of construction and that there is nothing glaringly wrong with the design.

Just like with a home purchase, the lender expects you to have a "down payment", they expect you to cover 20 to 25% the cost of the home with your own money. If you have already purchased the land, the lender may consider your equity in the land as this "buy-in". However, they still expect you to have some cash available to help pay for construction costs, generally 5 to 10% of the construction costs. The permanent loan may not require such a large equity stake as the construction loan. The permanent loan may require as little as 5 to 10% down and so you may be able to get some of your cash back out of the property when the permanent loan funds.




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