How do Construction Loans Work?

With rates low and the market unpredictable, you may be looking more closely at building your next home rather than buying an existing one. While building a home is an exciting endeavor, full of lots of design and architectural choices, there is one thing that has to be set up before any of that can happen – namely, your finances. In order to build the home of your dreams, you’ll likely need to get a construction loan. Read on to learn more about construction loans and how they work.

What Exactly is a Construction Loan?

In its simplest terms, a construction loan is a high-interest, short term loan provided to a buyer in order to build a residential property. Typically, these loans last less than a year and take into consideration the length of time it will take to build the residence as well as when it will be occupied. This loan is mainly meant to cover the cost of the builder when purchasing materials, tools and labor to complete the home. There are few other things that can be wrapped into the construction loan, including contractors, framing, interior finishes, permits and much more. Items that typically aren’t covered in a construction loan are ones that are removable – namely furniture.

How Do These Loans Work?

Because construction loans are considered a little bit higher risk, they typically come with higher loan rates. In a typical loan setting for a mortgage, the existing house acts as collateral. If you can’t make your payments then the lender (bank) can seize the home. With a construction loan, there is no preexisting home, thus no collateral.

Construction loans are mapped out using a timetable of completion from the builder. They need a realistic budget, detailed plan and timeline in order to go through with it.  Once the loan is approved, the builder then takes draws from the loan in stages while they complete the home rather than a single lump-sum. The borrower typically is only responsible for the interest payments during construction until the residential property is completed.

What Happens Once Construction is Done?

Once the construction is done, there are a few options available to a borrower. They might be able to convert that construction loan into a permanent, traditional mortgage, or they might have to get a second mortgage to help pay off the construction loan. The major benefit to the first option is that you only have to pay closing costs once on your loans, reducing fees.

 

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