Construction loan guide, step-by-step

1. What are the basics?

So what does a construction loan comprise of? A construction loan’s purpose is self-explanatory but typically it’s short-term – around a year. This allows borrowers to proceed to build and complete their home within a certain time frame. Funds are taken from the loan, or drawn, to pay for the materials and contractors hired for the project. The borrower is then only charged interest on what has been taken out at the time.

2. There are two types

Construction loans are mostly structured in two distinct ways: construction-to-permanent and stand-alone. A construction-to-permanent dictates that you only borrow what you need for the construction of the building. Once finished, the bank or lender morphs the current loan into a mortgage. It merges the two separate entities of the construction costs and the mortgage into one loan, which can reduce fees. Your variable interest rate during the construction phase can change to a fixed rate when converted to a mortgage.
A stand-alone construction loan pays for only the construction costs, and a completely separate loan is needed for the mortgage. If you already own a home and are waiting for the new one to be built, this type of loan can give you flexibility with a smaller down payment. However, you cannot lock in a mortgage rate. You will need to pay two separate fees for the mortgage and construction loans, as they are separate entities.

3. Qualifying for one

Sometimes it can be difficult to qualify for a quality construction loan because it is perceived as a bigger risk to the lender than a conventional loan. The fact is, the lender has to have faith in the borrower that the project will get done and that the property will have value once finished. If the value falls and the loan amount exceeds the value, it turns into a bad investment by the bank. Therefore, there are stricter requirements the borrow must meet before being approved such as hiring a qualified builder, presenting detailed specifications of the construction plans, getting the home value assessed by an appraiser, and putting a large down payment in place.

4. Draws

Draws are used during the construction process to receive funds to pay for each major phase of the building project. A foundation is laid, so 10% of the funds are given. The framing of the house is complete, another 10%, and then so on. To reduce risk and ensure their money is going where it should, required inspections of the construction are not uncommon by lenders before giving access to more of the loan. Once construction is complete and all draws have been given, the borrower must acquire the end loan to pay off the construction loan.

5. Paying interest only

The advantage of most construction loans is that unlike conventional mortgages, you only pay the interest, not the principle. On top of that, you only pay interest on what you have currently borrowed. So even though your loan might be $100,000, if you have only taken out $15,000, you only need to pay the interest on the $15,000 you have drawn out. Payments usually start out low and climb as you take out more to continue to build your home.

In conclusion, a construction loan is a way to ensure you get the funds you need to build the home you have always wanted. However, if you have questionable credit, not much financial wiggle room, or are unsure of exactly what you want your home to be, it might not be the best road to go down due to the risks involved. If you are curious about getting a construction loan and would like to begin the process, Magilla Loans is a free online loan search engine that connects borrowers with lenders from FDIC insured banks.