Construction loans are short-term loans used to finance the building of a home or another real estate project.
The builder or home buyer takes out a construction loan to cover the costs of the project before obtaining long-term funding. Because they are considered fairly risky, construction loans usually have higher interest rates than traditional mortgage loans.
Construction loans are usually taken out by builders or home buyers who are custom-building their own home. Once construction is completed, you can either refinance the construction loan into a permanent mortgage or get a new loan to pay off the construction loan.
At a minimum, most lenders require a 20% down payment on a construction loan, and some require as much as 25%. To gain approval for a construction loan, you’ll need to provide the lender with a comprehensive list of construction details and prove you have a qualified builder involved in the project.
Because local banks are familiar with the housing market in their area, they are generally more comfortable making home construction loans to borrowers in their community.
Funds are taken from the loan through a process referred to as a draw. A draw is the method by which funds are taken from the construction budget to pay material suppliers and contractors. Each lender has different requirements for processing a draw. For example, some allow the borrower to request draws online, while others require paperwork and periodic inspections. This process helps ensure that the loan proceeds are actually used for the construction and that the construction process is moving smoothly. The borrower is only charged interest on the amount borrowed at any one point.
Instead of paying each month during construction, almost all construction loans in the United States have extra funds borrowed right away and stored in a locked account known as an interest reserve. Each month the monthly payments are taken from the account so that the borrower does not have to start paying out of pocket until the project is completed.
Lenders attempt to mitigate their risk in a variety of ways. The first involves due diligence on the general contractor, architect, soil upon which the property is to be built, environmental inspections, and appraisals. Then, while the construction process is ongoing, the lenders carefully inspect progress both to ensure construction is proceeding smoothly, as well as to ensure that all workers are being paid so that the security of the loan by the real estate is not violated by a mechanics lien.
Rarely found online, construction loans are usually offered by local credit unions or regional banks. Because local banks are familiar with the housing market in their area, they are generally more comfortable making home construction loans to borrowers in their community. If you intend to act as your own general contractor or build the home with your own hands, you will likely need to take out a variant of this type of loan called an owner-builder construction loan.
Banks and mortgage lenders are often wary of issuing construction loans for many reasons. One major issue is that a lot of trust needs to be placed in the contractor undertaking the building work. 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 construction loans.
Once an applicant has qualified and been approved for a construction loan, the lender begins paying out the money they agreed to loan. Rather than provide all the money up-front, a schedule of draws is set up.
Draws 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 appropriately.
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