How does a construction loan work?

Construction loans finance the necessary materials, permits, and the labor required, should you wish to build a new home. Construction loans are typically offered by local or regional banks because the loan product meets their business objective –  to invest the bank’s assets wisely as well as locally. They are also planned and require extreme lead times. Construction loans, by their very nature, are a legitimate challenge for any lending newbie. And when you want to learn more, it always feels like you are learning a new concept, but in a different language. It is, however, worth the effort.

Years ago, construction loans were ridiculously hard to come by as many lenders refrained from even offering construction financing to their customers. An approval was a rare occurrence and usually followed by a celebration.  Fortunately for all of us, the approval process and implementation of construction loans have been streamlined over the past few decades. They are now more affordable than ever, with faster processing times.

It is imperative to understand the inner workings of a construction loan if you are to get the most bang for your construction dollar. These loans are admittedly complex financial instruments, but they are NOT impossible to navigate. Let’s see how it is done.

How are construction loan interest rates established?

Typically, the interest rates for construction financing are variable in nature, and are tied to an established financial index like Prime Rate. As construction loans are priced often a year in advance, it is priced slightly higher than its more popular cousin, the permanent mortgage.  Construction loans are short term financing instruments with a loan term that generally ranges from a fixed rate to a three to five year ARM.

The approval process for construction financing is intricate, and time-consuming, which is ultimately why you need to begin this process as early as possible. Additionally, the process requires the submission of typical borrower profile documentation, plans and specifications for the proposed home, the budget, and the project’s timetable. The information gathered to make a lending decision is often referred to as the ‘Story Behind the Loan.’

How do construction loans work?

Once secured, construction loans are routinely monitored by the lender to ensure that the proposed work is done on time and in accordance with the pre-approved construction schedule.   At regular intervals during the construction phase, the general contractor will request additional funds to cover the costs of the recent work. You should expect to see a lender’s representative somewhat often as they need to inspect the site to verify the progress.

Construction loans have no penalty for prepaying the financing early.  A borrower can lock in the permanent mortgage’s interest rate up to a year in advance.

Introducing the Interest Reserve!

During the scheduled construction period, a lender expects to be paid a minimum monthly interest payment. The interest due is calculated upon the outstanding construction loan balance at that time. Back during the decade that brought us ‘I love Lucy’ and ‘Leave it to Beaver’, construction loans were much more costly than they are now. This is because the modern construction loan now requires the establishment of an ‘Interest Reserve’ account, which funds the required monthly interest payments due during the construction phase. In other words, a borrower no longer has to pay TWO MORTGAGE PAYMENTS during their new home’s construction, making the loan more affordable from just this one perspective. This lending technique works like a credit card; only the credit limit often reaches six figures, or even more!

“Construction-to-Permanent” Loans

This specific loan product has revolutionized how construction lending works and, as such, it has now become the first choice among most borrowers.

Construction-to-Permanent loans permit a borrower to finance their entire project with only one lender. This reduces paperwork, hassle, and even closing costs, as one closing is all that is required for handle both financing phases.  The Certificate of Occupancy (CO) (or an equivalent) triggers:

– The conversion event (from construction to permanent)

– The lender’s final inspection

The permanent loan’s terms have been approved by all parties in advance, except for the final loan balance. This is based on the amount of funds drawn during construction.

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