Construction projects are expensive, regardless of whether they are renovations, expansions, or new homes. Construction financing can be an optimal approach for obtaining the funds necessary for labor, building materials, and other expenses.
Construction financing is a loan used to build a new house from the ground up. Also known as a “self-build loan,” this short-term loan covers the project’s costs before securing long-term financing, and either the builder or house buyer can apply for it. Due to their perceived risk, construction loans typically have a higher interest rate than conventional mortgage loans. The loan period generally runs for 12 months, and following the construction completion, the loan is either converted to a mortgage loan or paid off.
A construction loan functions similarly to a line of credit. Rather than paying all expenses upfront, the builder receives a series of disbursements called “draws.” When the builder requests a new draw for the next stage, a lender inspector will visit the site to check on progress. The construction financing line of credit stays in place for the duration of the building process (four to six months for the average home and up to a year for a custom executive home).
Prior to breaking ground, both the house buyer and the builder should be familiar with the lender’s draw schedule, which details when and how the lender issues the disbursements. Typically, the borrower can make interest-only payments on the loan during construction, as the interest charged is only on the amount disbursed.
Various types of construction loans exist to satisfy the varying demands of prospective homeowners—most notably, construction-to-permanent and construction-only loans. Different choices exist for owner-builders and homeowners doing major modifications on an existing home.
As the name suggests, a construction-to-permanent loan finances the construction of a home and then converts it to a fixed-rate mortgage upon completion. This option is suitable for homeowners interested in avoiding closing expenses and securing home finance.
With a construction-only loan, the lender makes a short-term, adjustable-rate loan to fund the construction of a home. Following completion of construction, the loan must be repaid in full or converted to a mortgage. This loan is suitable for homeowners with a sizable cash reserve or who plan on repaying the loan through the sale of their first property.
Several key benefits can be realized with this type of loan. While banks will need borrowers to provide them with detailed plans for the project, construction loans have significantly more flexible terms and limitations than traditional loans. This flexibility enables house buyers to tailor their loan terms to the project’s requirements to a certain extent.
In addition, the borrower is not required to repay the loan in full until the new construction is complete. The bank only requires the payment on the interest of the disbursed amount during the build, which results in a smaller monthly payment.
Once construction is complete, the financing converts to a mortgage-like loan. This may benefit house buyers who do not have adequate funds for loan repayment within the loan’s short term. Additionally, the borrower can negotiate and lock in the loan interest rate.
Like any other financial product, construction loans have some drawbacks. While it may appear straightforward, qualifying for a construction loan is not a simple and easy process. Lenders usually demand stricter qualification requirements in terms of credit scores and down payment.
Construction loans are often variable-rate loans, with lenders adding a percentage point above the prime rate or the rate they charge their best customers. For instance, if the prime rate is 4.5 percent and the lender determines that the interest rate on the construction loan should be prime + 2%, the borrower will have to pay a 6.5 percent interest rate.
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