How Construction Loans Work

Construction loans are designed to help individuals build or remodel their homes. The loan is built around an appraisal, land value, scope of work (new construction vs. renovating), a construction budget, the borrower's credit and assets.
Construction loans are more complex than purchase loans because of many factors. These include establishing an accurate budget, finding a contractor, receiving an appraisal that justifies the cost, and having the financial strength to secure the loan. Construction loans also encompass the payoff of the building site. Because construction loans are complex – and risky – they often carry higher interest rates and closing costs than a refinance or purchase loan.

Some construction loans only cover the actual construction term, while others are called “construction to permanent” loans. A construction to permanent loan means once the home is finished, the borrower modifies to the permanent financing of their choice. This can be the most favorable choice since there is only one set of closing costs.

Funds are taken from the loan through a process referred to as a “draw.” A draw is the method by which funds are taken from the construction budget to pay material suppliers and contractors. Each lender has different requirements for processing a draw. For example, some allow the borrower to request draws online, while others require paperwork and periodic inspections.

Construction loans usually last for 12, 15, or 18 month terms. During construction, interest payments on the project are paid through the loan. An “interest reserve” is set aside in the loan to make payments for the borrower. So, while building a home, a borrower is not required to make payments on the land or project.

This page was last modified 02:55, 21 December 2006.
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