Understanding Construction Loans

June 12, 2019 9:00 am Understanding Construction Loans Published by

What Is A Construction Loan And How Does It Work?

A construction loan is pretty self-explanatory. As the name implies, it is a loan that is taken for the purpose of building a home. These loans are most often obtained from banks and other financial institutions. There are relatively few of us that can actually afford to pay the cost of a construction project without some kind of loan. As such, these types of deals can be a great way of covering the cost. 

Types Of Construction Loans

There are two basic types of construction loans. The differences between these two loan types can be somewhat confusing because bankers and financial experts tend to speak in terms that are not plainly understandable for the average person. However, the whole thing isn’t particularly complicated.

Construction-Only

This is a loan that will cover only the costs of construction. Once the house is built, the entire loan is due immediately. These loans are good for those who are selling one home and using the proceeds of the sale to buy another home. These loans are not so good for borrowers who are not financially secure enough to cover the costs if something should go wrong.

These loans would also be a good choice for those who want to deal with two different lenders for one reason or another. It might be that you have more trust for one lender than you have for another. If this is the case, you might want to use two different lenders: one for the construction costs and one for the mortgage. However, it is not generally recommended. On the upside, this type of loan is usually easier to extend if you go over your budget. 

Construction-To-Permanent

This type of loan is a combination package, in which a loan for construction costs is combined with a mortgage. Once construction is completed, the remaining balance of the loan is immediately converted to a long-term mortgage. One of the best things about this plan is that you do not have to be approved twice. The process is likely to be a lot more streamlined and efficient. 

These are the most popular type of construction loan because they give you a lot more flexibility. Of course, this means that these loans require a little more trust on the part of the borrower. As such, it is a little harder to qualify for a Construction-To-Permanent loan. 

What Are The Terms Of This Deal?

Once you have been approved for the loan and the deal has been sealed, you will be liable for closing costs. Depending on which type of loan you have obtained, you will either have to pay one set of closing costs(construction-to-permanent) or two(construction-only). The money will typically be disbursed as a series of payments rather than a single lump sum. These payments (sometimes called “draws”) will usually be given out each time the construction process advances to the next phase

For instance, you might get the first payment as you begin the process of leveling the land and laying the foundation. You will not get the second payment until you reach the next stage of development. The disbursement schedule is something that you and your lender will have to work out on an individual basis, but it will probably follow this kind of pattern. 

Although this kind of arrangement may seem inconvenient, it will actually save you a little bit of money. You see, as soon as a sum of money is paid out, you are immediately liable for interest on that money. During the construction phase, you will have to pay interest on the loan, but you should not be liable for any additional payments. 

Interest rates will vary quite a bit with this type of loan. Like most interest rates, these will usually be determined by the national prime interest rate, which is set by the Federal Reserve. For instance, your contract might state “prime-plus-one” as the interest rate. This means that if the prime rate is two percent, your rate is three percent. However, some loans will allow you to fix the interest rate at the moment in which the deal was made. So, if the prime rate was one percent when the deal was made, it will remain as such for the duration of the contract.

How Do I Get A Construction Loan?

The first thing you will need to do is choose a lender. To go into all the factors that might influence your decision would be outside the scope of this article, but you should generally look for an institution that you have dealt with in the past, and whom you trust to some degree. You should also look at some reviews and testimonials to get an idea of the company’s customer satisfaction rate. 

Having chosen a lender, you will need to get pre-approved. This step of the process is essentially just a credit check. It is pretty easy to find out your credit score, although there may be a small fee involved. However, you should be aware that construction loans require a fairly high credit score. If you have bad credit, low credit, or no credit at all, you probably won’t qualify. In most cases, you will need a credit score of at least 680 to be approved for this type of loan. You will also most likely need to make a large down payment, typically about 20% of the total loan. 

As part of the approval process, the lender will probably do an appraisal. This means that the company will send an inspector to check your proposed building site. It goes without saying that you will have to buy a piece of land on which to put your home, and the inspector’s job will be to make sure that the price of this land is equal to (or greater than) its actual market value.

Your lender will also want to check out your contractors, as well as any subcontractors they might be employing. This might include credit checks, criminal background checks, checking with the Better Business Bureau, looking at various reviews and testimonials, and (most importantly) checking to make sure that the contractors are certified and in possession of all the appropriate licenses.

The lender’s agents will also want to look at your finances to see if you can afford to pay them back while still meeting the basic expenses of life. If you cannot do this, it would be very foolish of them to loan you any money. They will also want to take a look at your floor plan to see if this building project meets their expectations. 

All of this will become a theme: inspections, inspections, and more inspections. The bad part is that you can’t blame the lender for this. After all, they have ponied up a lot of money, and they have every right to protect their investment by checking up on things. At every step of the construction process, you should keep your lender well-informed.

Risks To Consider:

There are some risks with a loan of this type, and most of them stem from the fact that you are investing in a property that does not yet exist. The whole thing is a highly speculative matter, which is a fancy way of saying that it’s a gamble. In life, as in poker, you should never gamble that which you cannot afford to lose.

Many people will sell their own home and use the money from the sale to build a new home. This is a pretty good plan, but you need to ask yourself: What if the house doesn’t sell before construction is complete and the loan is due? What if the house sells for significantly less than expected? Either of these problems can leave you on the hook for a lot of money that you may not have. 

Going over your budget can also be a serious problem. All it takes is a price hike on key building materials, a single accident, or some unexpected terrain to increase your costs and leave your project short on funds. If this happens, you will need to request more money from the bank. If they are unwilling to do so, you essentially have three choices at that point. You can either continue and make the best of the situation, try to obtain the money from another lender, or seek a way to cancel your contract with the lender. 

Of the above choices, option one is obviously the best thing to do. You will have to compromise your plans in order to cut costs and make up for the shortfall. This means that you won’t get what you wanted, but the project will still be completed. Option two will complicate the matter and introduce a whole new level of debt, while option three is very difficult and will probably cost a bundle in terms of legal fees. 

This kind of loan is also risky for the lender. If the construction turns out to be faulty, and an accident happens, the lender is one of the people who can be held liable for damages. Apart from this, they also face the obvious danger that you will fail to pay back the loans and leave them at a loss. 

Both you and the lender could end up taking a loss if the housing market (which can sometimes be quite volatile) happens to drop sharply. When this happens, the value of the property might be less than the costs of construction. Of course, the upside of this situation is the fact that your home could also end up becoming more valuable than expected.

An additional element of risk comes from the employment of contractors and subcontractors. As a general rule, their mistakes become your problems. Since you are the one who chooses the contractors, you need to make sure that they do not make you look bad or ruin your project. 

Common Questions:

What will happen if my construction project suffers a delay?
As the old saying goes, time is money. Whenever unexpected delays occur, it will usually take money to correct the problem. In some cases, you might get lucky and avoid additional costs, but this is rare. At the bare minimum, delays will affect your standing with the lender. This is why you should always try to negotiate for a little bit more time than you actually need. 

My lender is requesting a large amount of personal information. Is this normal?
In a word, yes. As long as you are dealing with a licensed and accredited financial institution, you don’t need to worry a whole lot about this issue. Your bank is probably just trying to make sure that you will be able to pay them back for this huge amount of money that you are about to borrow. Wouldn’t you want to do the same? At the same time, remember that any information not related to your finances can and should be withheld. 

Conclusion:

If you have ever wondered where people obtain the kind of money that is required for large construction projects, this article should have answered your question. Most construction projects are funded by banks, simply because they are the ones in the best position to offer such funding. This is a good thing, as studies have found that lack of construction-related finance services can have a stifling effect on architectural development and innovation.

We hope that this article has given you a better understanding of construction home loans. It is essential that you understand these basic concepts before you even talk to a single potential lender, as it will save time and allow you to avoid making a deal that will not meet your desires. Please fill out the contact form below if you have found this article to be helpful.