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Construction Loans: A Construction Financing Guide

How Do Construction Loans Work?

A construction loan, as the name suggests, is a type of loan that is used to finance the construction of a new home or other real estate property. These home construction loans are typically interest-only loans, meaning that the monthly payment only covers the interest on the loan and does not go toward the principal balance of the loan during the construction period. Once the construction is complete, you will need to refinance the loan into a traditional mortgage.  

Construction loans for homes and other projects are typically used by homebuilders and developers, and they are usually not available to consumers. This isn’t that bad though as the interest rate on a construction loan is typically higher than the interest rate on a traditional mortgage. This is because they are considered riskier than mortgages. 

They are paid out in installments, called draws. As each phase of the construction project is completed, the lender will release a portion of the loan funds to you. That’s why it is especially important to carefully track your expenses during the construction process so that you do not overspend and end up with an unfinished project.  

What is a Construction Loan?

Construction loans are a type of short-term loan typically used to finance the construction of a new home or other real estate projects. They are issued by banks or other financial institutions and are secured by the property being financed.  

They generally have short-term with variable interest rates. The repayment period for a construction loan is usually 12 months or less, after which the loan is converted to a permanent mortgage.  

Construction loans can also be used to finance the purchase of land. These loans are typically issued at 80% of the value of the property being financed. This means that you will need to have 20% of the purchase price in cash or equity in order to qualify for a loan.  

If you are planning on financing the construction of a home, it is important to understand all of your options before choosing a loan. These loans can be an attractive option for borrowers who may not qualify for traditional mortgages due to their credit history or lack of equity in their homes. However, they will likely be more expensive than traditional mortgages and carry more risk, so it is important to weigh all of your options carefully before making a decision.  

How Do Construction Loans Work?

These loans are a bit more complicated than other types of loans so let’s thoroughly cover how do construction loans work.  

First of all, it’s important to know that they are made based on the value of the property being built. Construction loans are made by banks or other financial institutions and are paid out in installments as construction progresses.  

Once the loan is approved, it will be disbursed in installments as construction progresses. Typically, the lender will release funds based on a predetermined schedule of milestones such as completion of the foundation or framing. As each milestone is reached, more funds are released until the loan is fully disbursed.  

At the end of construction, most lenders will require that the loan be refinanced into a traditional mortgage. This allows them to get their money back plus interest and also gives you a chance to lock in a lower interest rate if rates have gone down since you originally got your construction loan.  

How to Get a Construction Loan

The first step in getting a construction loan is to find a lender that offers them. Once you have found a lender, you will need to fill out an application and provide any required documentation. The lender will then appraise the property to be sure that it is worth what you are borrowing.  

If everything goes smoothly you should shortly be approved for the loan. And as we said the lender will release funds based on a predetermined schedule you agreed on.  

Construction Loan Requirements

To qualify for a construction loan, lenders will typically require that you have a credit score of at least 620 and a down payment of at least 20%. They may also require that you have a verifiable income source and a debt-to-income ratio of no more than 43%.   

Aside from these requirements, you’ll need to know the specifics of your project when applying for a construction loan. Prior to submitting an application, you should consult an architect about developing plans and arranging a contract with a general contractor.  

Your lender will want to learn more about the project’s details. So, you’ll need to supply relevant information about the house’s dimensions and the materials the contractor will use. The more information you provide, the better.  

Different Types of Construction Loans

There are many different types of construction loans available to owners and builders. The most common type of loan is the construction-to-permanent loan, which allows borrowers to finance the cost of construction and then convert the loan to a permanent mortgage when the home is complete.  

Other types of construction loans we haven’t talked about include:  

  • Construction-only loans. These loans are typically used by builders who plan to sell the home before it is completed. Borrowers will make interest-only payments during construction and then pay off the loan in full when the home is sold.  
  • Renovation construction loans. Renovation loans are designed to finance the cost of repairs or renovations on an existing home. These loans can be used to fund major projects such as kitchen or bathroom remodels, or they can be used for smaller projects like painting or minor repairs. They are also known as construction remodeling loans.  
  • Commercial construction loans. They are kind of a business loan that helps the company cover the costs associated with building or renovating structures. They can also be used to purchase land, buy materials and pay workers.  

Construction Loans vs. Traditional Mortgage: What’s the Difference?

By now you are probably familiar with both but let’s once again define both so we can highlight their differences.  

Construction loans help finance the construction of a new home. They have much shorter terms than traditional mortgages and may require the borrower to make interest-only payments during the construction phase. After the home is built, the loan converts into a permanent mortgage.  

Traditional mortgages, on the other hand, are used to finance the purchase of an existing home. The terms are longer, and the borrower may be able to make lower monthly payments because the loan is spread out over a larger period of time.  

What is Covered by Construction Loan?

Here are some things a construction loan can be used to cover:  

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

It’s important to discuss these items with your lender, specifically what will be included in your loan-to-value calculation.   

Bottom Line

There are a few things to consider before taking out a construction loan, such as the time frame of the project, the amount of money needed, and the interest rate. In general, you can expect construction loan interest rates to be between 5 and 10 percent. This is why it is important for you to take your time while searching for a good lender.  

The bottom line is that these loans can be a great way to finance your home improvement project or build a home from scratch. But you need to make sure you understand all the terms and conditions before you commit.  

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