What is a Construction Loan?

Published on May 9, 2019 under Loan Programs

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A construction loan is a short-term loan (generally up to one year) intended to finance the building of a real estate project - for individuals, this generally means a home. Construction loans are taken out if you have bought a bare lot or a tear down. Interest rates tend to be higher than on traditional mortgages due to the lack of major collateral.

So, what does it take to get a construction loan? Generally you do have to jump through some extra hoops. You will need to have a good credit history and the lender will also want to see the architectural plans and talk to the builder (lenders may expect you to use an approved builder). It may be difficult to secure a construction loan if you plan on building the house yourself.

Types of Construction Loans

There are 2 types of construction loans most often offered by lenders:

1. Close construction loan: these construction loans automatically convert into a permanent loan when construction is complete and have a longer amortization period than 1 year. These loans are generally less costly than the two close as you only have to pay one set of closing costs. Monthly payments are interest only based on the amount drawn and become amortizing payments once the construction is complete and a certificate of occupancy is issued.

2. Close or construction only loans: these construction loans must be paid off when construction is completed. This is most commonly done by refinancing the loan into a permanent loan that amortized over the specified period (generally 15 or 30 years). Monthly payments are interest only based on the amount drawn and generally have a balloon payment at maturity.

How Does a Construction Loan Work?

No matter the type of construction loan you get, you will find that they both work differently from mortgages. In a mortgage, you receive a lump sum amount to buy the house. Construction loans are paid in installments, known as "draws", and are paid not to you but to the builder. The idea is that the builder is paid for the draws as they incur the costs to build - this reduces the risk to the lender and also keeps the builder from absconding with all of the cash.

A construction loan can make the difference between being able to design your own home to fit your exact needs and having to shop around to find a home with a layout or finishes that may not be ideal to you. Construction loans are for people who can afford to make a decent down payment, who want a new home, and who are willing to provide all the information the lender may require.

What is required for a construction loan?

If you are considering a construction loan, it may be a good idea to get your plans approved by the local building authority before trying to get the loan. Make sure that you discuss a reasonable construction schedule with the builder that allows for weather delays and similar. The lender will want to ensure the project is continually progressing. Get yourself prequalified for the loan once your plans are set and make sure that you choose a lender with experience that can walk you through the stressful process of building a home.

In short: If you are looking into buying a lot or tear down and building your own home, you should consider getting a construction loan to finance it. Although they can be hard to get, these loans are well worth the extra hassle if you aspire to design your own house based on your requisites. Speak with a loan officer to discuss further what a construction loan entails; if you're in the Washington, D.C. area, make First Savings Mortgage your advisor of choice.

Please note, by refinancing your existing loan, your total finance charges may be higher over the life of the loan.

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