Construction Loans: 5 Questions Answered About the Financing

A home construction loan represents financing used to cover the building of a residential property. The loan term, which usually covers a year, allows for the building to proceed and end with the issuance of a certificate of occupancy.

1. What Are the Features of Construction Loans?

Typically, a construction loan features variable interest rates that fluctuate in lockstep with the prime rate. Click here to understand why rates on construction loans are usually higher than conventional mortgages. 

With a conventional mortgage, your house serves as collateral. Therefore, if you default, the lender can seize the property. The interest rate on a construction loan is higher, as the financing is not collateralized. This places the lender at an increased risk.

Due to the brevity of the construction, you must present the lender with a construction timeframe, precise designs, and a realistic budget to obtain construction financing.

Once you are approved, you, as the borrower, are placed on a draft or draw schedule – an itinerary that correlates to a project’s construction phases. At this point, you normally are responsible for paying just-interest payments. Unlike a personal loan, which requires paying out one payment, the lender allocates funds in stages, or as the building progresses.

During construction, the lender contacts an inspector/appraiser to review the process at different stages. About four to six inspections are performed while tracking building progress.

To speed up the loan process, you can use a hard money lender Рa company that facilitates the financing in several days. Traditional lenders often stretch the approval process over three to four weeks, with some governmental programs, like HUD, sanctioning financing after several months. 

While you may pay a higher interest rate, you can also get things underway faster, which allows for more flexibility, particularly if you need to meet a deadline.

2. What Does a Construction Loan Cover?

Construction loans cover the following items:

  • The cost of the land
  • Contracted labor
  • Building permits
  • Building materials
  • Appliances
  • Landscaping

Furnishings are not covered under construction financing.

3. What Type of Down Payment Do You Need for Construction Financing?

You usually need to place a down payment of 20% to 30% to build a residential property. However, some renovation loan programs, such as the FHA 203(k) program, allow low 3.5% down payments.

4. Is Private Mortgage Insurance Required for Construction Financing?

Private Mortgage Insurance (PMI) is required if a borrower puts less than 20% down for the financing.

5. What Are the Types of Construction Financing?

Construction loans are available in the following forms.

Construction-to-Permanent Loan

This loan allows you to borrow money to pay for the building of your home after which the loan is converted to a permanent mortgage of 15 to 30 years. You only have one set of closing costs to pay, thereby lowering the overall cost.

Construction-Only Loan

This type of construction financing only covers the funds needed to complete the construction. The borrower must either pay the loan when it matures (in one year or less) or obtain a mortgage to secure permanent financing. If you plan to obtain a mortgage, it is far less costly to opt for the construction-to-permanent loan.

Renovation Loan

This type of construction financing covers an existing house versus a newly built home. If you plan to spend under $20,000 for improvements, you might consider using a credit card or taking out a personal loan. If the total cost is at least $25,000, a line of credit or home equity loan might work for you, as long as you have built up some equity.

Owner-Builder Construction Loan

This type of loan represents a construction-only or construction-to-permanent financing where the borrower acts as the home builder. Normally, you cannot do this, as a borrower, unless you are licensed in the construction trade.

Conclusion

Review your options for loans carefully when taking out construction financing. By scrutinizing your building plans, you can save on costs and meet each milestone successfully. Opting for the services of a hard money lender will give you an edge, especially if you are working within a specific timeframe.

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