What is a Construction Loan?

A construction loan is typically a short-term loan used to pay for the cost of building a home. It may be offered for a set term (usually around a year) to allow you the time to build your home. At the end of the construction process, and the house is completed, your loan converts to a permanent longer term mortgage.  This is called an all in one loan.

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Qualifying for a Construction Loan

Banks and mortgage lenders are often leery of construction loans for many reasons. One major issue is that you need to place a lot of trust in the builder. The bank or lender is lending money for something that is to be constructed, with the assumption that it will have a certain value when it is finished. If things go wrong – for instance, if the builder does a poor job or if property values fall – then it could turn out that the bank has made a bad investment and that the property isn’t worth as much as the loan. To try to protect themselves from this problematic outcome, banks often impose strict qualifying requirements for a construction loan. These usually include the following provisions:

1.    A Qualified Builder Must Be Involved. A qualified builder is a licensed general contractor with an established reputation for building quality homes. This means that you may have an especially hard time finding an institution to finance your project if you are intending to act as your own general contractor, or if you are involved in an owner/builder situation.

2.    The Lender Needs Detailed Specifications. This includes floor plans, as well as details about the materials that are going to be used in the home. Builders often put together a comprehensive list of all details (sometimes called the “blue book”); details generally include everything from ceiling heights to the type of home insulation to be used.

3.    The Home Value Must Be Estimated by an Appraiser. Although it can seem difficult to appraise something that doesn’t exist, the lender must have an appraiser consider the blue book and specs of the house, as well as the value of the land that the home is being built on. These calculations are then compared to other similar houses with similar locations, similar features, and similar size. These other houses are called “comps,” and an appraised value is determined based on the comps.

4.    You Will Need to Put Down a Large Down Payment. Typically, 20% is the minimum you need to put down for a construction loan – some lenders require as much as 25% down. This ensures that you are invested in the project and won’t just walk away if things go wrong. This also protects the bank or lender in case the house doesn’t turn out to be worth as much as they expected.

Providing that you meet all these criteria and have good credit, you should be able to qualify for a construction loan. Generally, lenders also require information regarding your income (to be sure you can afford the mortgage payments) and your current home, just as they would with any type of standard mortgage loan.

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How Construction Loans Work

Once you have qualified for and been approved for a construction loan, the lender begins paying out the money they agreed to loan to you. However, they are not just going to give the builder the cash all at once. Instead, a schedule of draws is set up.DrawsDraws are designated intervals at which the builder can receive the funds to continue with the project. There may be several draws throughout the duration of the build. For instance, the builder may get the first 10% when the loan closes, and the next 10% after the lot is cleared and the foundation is poured. The next influx of money may come after the house is framed, and then the subsequent payout after the house is under roof and sealed up.

The number of draws and the amount of each is negotiated between the builder, the buyer, and the bank. Typically, the first draw comes from the buyer’s down payment (so it is the buyer’s money most at risk). It is also common for the bank to require an inspection at each stage before releasing the money to the builder. This helps to ensure that everything is on track and that the money is being spent as it should.

The Construction Loan Rate

With a construction loan, as with all other loans, you must pay interest on the money you borrow. Typically, construction loans are variable rate loans, and the rate is set at a “spread” to the prime rate. Essentially, this means that the interest rate is equal to prime plus a certain amount. If the prime rate is 3%, for example, and your rate is prime-plus-one, then you would pay a 4% interest rate (which would adjust as the prime rate changes).

In many cases, construction loans are also set up as interest-only loans. This means you only pay interest on the money you have borrowed instead of paying down any part of the principle loan balance. This makes payment of construction loans more feasible.

You also pay only on the amount that has been paid out already. For instance, if you are borrowing $100,000, and only the first $10,000 has been paid out, you pay interest only on the first $10,000 and not on the full $100,000. You need to make monthly payments for this loan – just as with a conventional loan – so your monthly payments should start low when only a small amount has been borrowed, and gradually increase as more of the money is paid out to your builder.

Disadvantages

Construction loans make it possible to build a home when you might otherwise be unable to do so. Building a home can be a great experience if you want to design something unique or specific to your needs and the needs of your family. However, there is also significantly greater risk when procuring construction loans than just purchasing an existing home.Some of the potential risks include:The Home Will Not Be Completed on Schedule and on Budget. If your house is not completed according to schedule, you may have to pay additional costs for rental accommodations, or pay two mortgages for longer than expected since you won’t be able to move in. In some cases, the final payment on your construction loan will become due and you will have to pay a fee to extend that loan – at least, until the house is finished.

 When Finished, the Home Will Not Be Worth at Least as Much as It Cost to Build. You could encounter this unfortunate situation if the builder does a poor job, or if the overall housing market plummets.

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Final Word

If you are willing to take on the risks of a construction loan, and you have the financial cushion available to help you through the bumps in the road, a construction loan may be the right choice so you can build your dream home.However, if you are just looking for a place to live, if you don’t have the emergency fund to deal with building setbacks, or if you are nervous about the home building process, then you may be better off choosing to simply purchase an existing home using a conventional loan. Carefully weighing the risks and benefits is important so you know that the choice you make is the right one for you.