Construction Loans

Construction loans are a common type of loan used in the building process. They differ dramatically in form and purpose from a typical mortgage loan.

Construction loans require the banker or the lender to know what is being built, and its exact purpose. A construction lender must know this information before they are willing to loan money. This also means that it is not going to be “standardized” like mortgage loans. This means it is not underwritten to Freddie Mac or Fannie Mae guidelines. There are some similarities to a construction loan. Construction loans frequently require interest-only payments while in construction, and then become due upon completion. Completion for a homeowner is defined as when the house gets its certificate of occupancy.

Construction loans are usually variable-rate loans. These are typically priced at some spread to the prime rate. It is worth shopping this around because the spread can be significant. The contractor, you, and the banker or lender establish a schedule of draws and target points based on the stages and completion of major points in the construction process. Interest is then charged on the amount of money disbursed to date.

Another factor in the construction loan is how much of the project-cost the lending agent is willing to lend. This is often a fixed % of the value. If you already own the land, this can be considered as equity on the construction loan.

Often home owners use permanent construction financing programs. This allows the construction loan to be converted to a mortgage loan after the occupancy certificate is issued. The advantage of this is you only have one application and one closing with a bank.

Another factor to consider is the trend of the interest rates. You can purchase what is called a rate lock agreement that is valid until the completion of the construction. This can protect you from being shut out on a good interest rate while you are doing construction on your home. Make sure that you allow plenty of time for any construction delays if you take this option.

As mentioned in the opening sentence, a construction loan is not like a mortgage. It is not meant to last for a long time. If you take out a $300,000 construction loan for six months and you pay an extra 0.5 percent on the loan, it costs you an additional $375. (This is assuming the average loan balance of $150,000 over the construction period of six months.)

Construction loans are a vital and necessary part of the building process. Just make sure that you shop around, protect yourself, and be wise in scheduling when you lock on your mortgage interest rate for long term payment off the home. It may be wise to consider even paying a higher rate on the construction loan if you're doing construction-to-permanent financing and it looks like you can get better mortgage terms or a longer, better rate lock from the lender.