What Are Construction Loans? How Do They Work?

You may be interested in what it would cost to build a house or to renovate the one that you have. It is very different to get a mortgage for a new property to finance this project. Here are the details about getting a construction loan through construction finance brokers.

What Is The Construction Loan?

A home construction loan, which is a shorter-term loan with higher-interest rates that allows you to purchase the funds needed to build your residential property, is available.

Construction loans usually last for one year. This period is when the property must be constructed and a certificate should be issued.

How Does A Construction Loan Work?

Construction loans often have variable rates, which move with the prime. Construction loan rates tend to be higher than traditional mortgage loan rates. A traditional mortgage uses your home as collateral. The lender can take over your home if you default on payments. A home construction loan is not available to the lender. Therefore, they view these loans more as larger risks.

Construction loans require a fast time frame and depend on completion. Therefore, it is important to provide a timeline, detailed plans, and a realistic budget to the lender.

Once approved, the borrower is placed on a draft/draw schedule that corresponds to the project’s stages. The borrower will usually only make interest payments during construction. The lender doesn’t pay the money out in one lump-sum payment like a personal loan.

These draws are usually made when significant milestones are reached — such as the foundation being laid or the framing and construction of the house. Borrowers have no obligation to repay interest until the construction is complete.

The lender hires an appraiser to inspect the house as it is being constructed. Once the appraisal has been approved, the lender will make additional payments to the contractor known as draws. You can expect to be subject to between four and six inspections to track the progress.

Depending on which type of construction loan the borrower has, he or she may be able to convert the construction loan to a conventional mortgage once the home is built. This is known as a construction-to-permanent loan. The borrower may need to obtain a separate mortgage to repay the construction loan if the loan is for only the construction phase.

What’s A Construction Loan?

You can use a construction loan for:

  • The cost of the land
  • Contractor labor
  • Building materials
  • Permits

However, permanent fixtures such as landscaping and appliances are usually not covered under a construction loan.

 Types Of Construction Loans

Construction-To-Permanent Loan

After that, you will make monthly payments to cover the principal and interest.

Construction-Only Loan

A construction-only mortgage provides funds to finish the home’s construction. The borrower will have to pay it off at the end of its term (typically within one year) or obtain a mortgage to permanent financing.

The percentage of the project that has been completed determines how much money is available. Interest payments are not due to the borrower.

Because you must complete two separate loans and pay two sets of fees, the construction-only loan can end up being more costly than permanent mortgages. Closing costs are often thousands of dollars so it’s a good idea not to have another set.

You should also consider that your financial situation may change during construction. A mortgage might not be possible if you lose your job or experience other hardships.

Renovation Loan

You may be interested in home improvement loans if you prefer to remodel an existing home over building one. There are many options available depending on how much money you spend on the project.

In the current low Mortgage Rate environment, another option is a Cash-out Refinance. A homeowner would take out an additional mortgage at a higher amount than their current loan and receive the overage as a lump sum.

The lender will generally not ask for disclosures about how the homeowner plans to use the funds. The homeowner controls the budget, plan, and payments. Other forms of financing will require the lender to evaluate the builder and review the budget. They will also oversee the draw schedule.

Owner-Builder Construction Loan

Due to the complexity of building a home, and the knowledge required to meet building codes, many lenders won’t allow borrowers to be their builders. This is usually only allowed by lenders who are licensed, builders.