What Is a Construction Loan?

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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, when the house is done, you will need to get a new loan to pay off the construction loan – this is sometimes called the “end loan.”

Essentially, this means you must refinance at the end of the term and enter into a brand new loan of your choosing (such as a fixed-rate 30-year mortgage) that is a more conventional financing option for your newly completed house.

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.

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.

Draws

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 as it should.

Once all the draws have been paid out and the home is built, the buyer then needs to get the end loan in order to pay off the construction loan.

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.