How Do Construction Loans Work?

With our house construction plans in hand and the contract details being hammered out, it’s time to look at the financial side of things. Though we’re bringing a decent chunk of cash to the project, we’ll be financing at least a portion of the build process with a construction loan.

Construction loans vs. mortgages

Construction loans are essentially large, short-term credit lines that can be drawn on to cover the costs of construction. Thus, they have very little in common with traditional mortgages, which are typically made for fixed amounts and amortized over longer time periods.

Once approved, you’ll be granted access to a credit line up to a certain amount. Chunks of that will then be freed up to pay to contractor as the work progresses, and you’ll make interest-only payments on the accrued balance over the life of the loan — typically 9-12 months at the most.

Once the house is done, the construction loan needs to be paid off. In most cases, this involves taking out a traditional mortgage and using the proceeds to pay off the construction loan, though it may be possible to set this up on the front end using a construction-to-permanent (C2P) loan.

Who gets the loan?

In the past, it was common for builders to secure the construction loan, build the house, and then sell it to the new owner. It still works this way for so-called ‘spec’ builds and in many tract developments, but the world has changed for truly custom home building.

Nowadays, it’s up to the prospective owner to secure the construction lean for their custom home build — or at least that’s the case around here. This protects the builder from getting stuck with the loan and the partially built house if the buyer has a change of heart in the middle of the project.

Believe it or not, even when there were substantial deposits at stake, many buyers walked away from home-building projects during the housing crash in favor of cheaper foreclosures. The end result for many builders was financial disaster, as they couldn’t handle the carrying costs.

How construction loans work

As noted above, construction loans are essentially credit lines that can be used to cover the cost of construction. As your project progresses, the builder will request a “draw” to offset any costs that he has incurred.

Once the draw request has been approved, a portion of your loan will be made available for you to pay the builder. From this point forward, you’ll make interest-only payments on the accrued balance. This is an important point because, if you use your own money first, you can avoid making interest payments until you absolutely need to draw on the loan.

Speaking of your own money…

The banks that we spoke with all required their borrowers to have “skin in the game.” In general terms, this involved covering 10%-20% of the constructions costs ourselves. We’re planning on satisfying this requirement by purchasing the lot with our own cash.

Note that, when a draw request comes in, the bank will (or at least should) go out and check that the work has been done before approving it. This is why most construction loans are handled locally. Just be aware that the bank isn’t assessing the quality of the work — they only care that it’s been done.

As for how much money can be disbursed at each stage… The bank will follow a “draw schedule” that specifies the percentage of funds should be released as various stages of the work are completed. As things get done, more of your loan is made available.

Finding a construction loan

When choosing our lender, we shopped around to three local banks. Two offered standard constructions loans, while the 3rd offered a more complicated C2P arrangement with a single closing covering both the construction loan and the eventual mortgage.

The advantage of the C2P loan is (arguably) less in the way of closing costs, but the overall difference in fees ended up being very small, and there were other aspects of dealing with that particular bank that we didn’t like. Thus, we went with a standard construction loan from another local lender.

In all cases, the banks were asking for a 0.5% origination fee along with some standard closing-related expenses. In short, we had to cover the appraisal, the title work, and the deed release/recording fees. One bank had a $300 fee for up to six draw-related inspections, the others didn’t.

The application process was straightforward. We had to complete a fairly standard loan application, provide the bank with some financial information (pay stubs, bank and investment statement, etc.), submit to a credit check, and so forth. We’ll also need to submit a copy of the finalized contract and house plans as part of the approval (and appraisal) process.

Once everything is in order, the approval process should take 10-14 days, most of which appears to be spent waiting on the appraisal. That’s pretty much it. If you have any questions, feel free to ask.

Financial, Getting Started
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