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How Construction Loans Work

How Construction Loans Work

  • Program Overview
  • A construction loan is a short-term mortgage that enables a borrower to finance the cost of building a new home or significant renovations including for a tear-down or fixer upper.  Construction loans are typically six months to a year in length depending on the schedule to build or remodel the property.  Most construction loans are interest only mortgages so the borrower pays only interest and no principal over the course of the mortgage.  Although the interest rate on a construction loan is typically higher than the interest rate on a regular mortgage, the mortgage payments are lower because the borrower only pays interest.  Please note that the outstanding principal balance of the mortgage is not reduced with an interest only mortgage.

    When the property construction or renovation is completed the borrower pays off the construction loan typically by refinancing it with a permanent mortgage.  In many cases the construction loan lender also provides the permanent loan.  If the construction loan lender does not provide permanent mortgages they usually require that the borrower has arranged a lender to provide the permanent mortgage before finalizing the construction loan. 

  • Great Mortgage IdeaInstead of arranging two separate loans it typically saves the borrower money and time to obtain a construction to permanent (C2P) loan which enables you to finance construction or renovation costs with one mortgage instead of two
  • The downside to a construction loan is that you have to apply for the permanent mortgage after the construction is complete. Your financial or employment circumstances may have changed over the course of construction which may make it more challenging to qualify for the permanent mortgage. Additionally, interest rates may have increased during the construction process which makes the permanent loan more expensive. To avoid these complications, we recommend that you arrange the permanent mortgage at the same time as the construction loan or apply for a construction to permanent loan or C2P loan, which is a single mortgage that includes both loans.

  • How Construction Loans Work
  • Instead of receiving the full proceeds from the construction loan immediately after the mortgage closes, the proceeds from the loan are disbursed, or drawn down, over time based on the financing required to complete the construction.  This draw down mechanism helps reduce financing costs for the borrower during the construction phase because you only pay interest on the funds you have drawn down as opposed to paying both interest and principal on the total amount of the construction loan.

    For example, a borrower may obtain a $250,000 construction loan but only receive $25,000 initially when the mortgage closes based on the amount of work expected to be done within the first month of the project.  In this case, for the first month, the borrower will only pay interest on the $25,000 initially drawn down as opposed to paying interest and principal on the full $250,000 loan amount, which saves the borrower a significant amount of money.

    Use the FREEandCLEAR Lender directory to find top-rated lenders that offer construction loans.

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  • The draw down schedule is typically agreed to by the lender, borrower and contractor before the loan closes and reflects the construction timetable and financing requirements for the project.  Additionally, in most cases lenders require ongoing inspections at each stage of the construction process before releasing additional funds to the borrower.  The inspections ensure that work on the construction or renovation project is proceeding according to the plans and timetable originally submitted by the borrower and that all contractors are being paid as the project progresses.  Lenders may not release additional disbursements if there are liens on a property such as a claim from an unpaid contractor.  Please note that inspections are performed to verify the progress of the project and not the quality of the construction or renovations. It is up to borrowers to make sure that the quality of the work meets their standards. 

    When all of the planned work is finished, a final inspection is performed to confirm that construction is completed and the inspector issues a certificate of occupancy verifying that the property is suitable to live in.  The lender also confirms that there are no outstanding liens on the property.  At this point, the borrower repays the construction loan in full, typically by refinancing it with a permanent mortgage. 

  • What Lenders Offer Construction Loans?
  • Not all lenders offer construction loans but many do. The best lenders for construction loans include:

    • Regional banks
    • Credit unions
    • Banks that you have an existing relationship with including having a checking, savings or investment account with the bank
    • Specialty lenders that focus on construction loans

    Contact the lenders listed in the table below to determine if they offer construction loans.  We recommend that you compare multiple mortgage proposals as construction loan terms vary by lender, project and other factors. 

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    Points  More Info:
    Points: Fees you are willing to pay in order to get a lower interest rate. The number of points refers to the percentage of the loan amount that you would pay. For example, "2 points" means a charge of 2% of the loan amount.
     
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    Monthly Housing Payments
    P & I More Info
    Principal & Interest: A periodic payment, usually paid monthly, that includes the interest charges for the period plus an amount applied to the reduction of the principal balance.
    Mortgage Insurance More Info
    Mortgage Insurance: The monthly cost for a policy that protects the lender in case you’re unable to repay the full amount of the loan. It is typically required for loans that have a loan-to-value ratio between 80% to 100%.
    (Estimated)
    Property Tax More Info
    Property Tax: (Also called "Real Estate Tax.") Property taxes are government assessments on real estate property. With mortgage financing, the local, county or state tax assessment on real estate property is considered part of the monthly housing obligation and typically collected and set aside by the lender ...
    (Estimated)
    Homeowner Insurance More Info
    Homeowner Insurance: or also commonly called hazard insurance, is the type of property insurance that covers private homes. It is an insurance policy that combines various personal insurance protections, which can include losses occurring to one’s home, its contents, loss of its use, or loss of other personal possessions of the homeowner, as well as liability insurance for accidents that may happen at the home or at the hands of the homeowner within the policy territory.lender ...
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    Homeowner Association Fee More Info
    Homeowner Association fee: (HOA) fees are funds that are collected from homeowners in a condominium complex to obtain the income needed to pay (typically) for master insurance, exterior and interior (as appropriate) maintenance, landscaping, water, sewer, and garbage costs.
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    Points More Info
    Points Fees you are willing to pay in order to get a lower interest rate. The number of points refers to the percentage of the loan amount that you would pay. For example, "2 points" means a charge of 2% of the loan amount.
    Origination Fee More Info
    Origination Charge: A loan origination charge is a fee charged by the lender for evaluating, processing, and closing the loan.
    Credit Report Fee More Info
    Credit Report Fee: Fee charged to obtain an applicant’s credit history prepared by one or all of the three major credit bureaus. Used by lender to determine the borrower’s creditworthiness.
    Tax Service Fee More Info
    Tax Service Fee: A fee charged by the lender to cover the cost of retaining a tax service agency. These agencies monitor the property tax payments on the property and report the results to the lender.
    Processing Fee More Info
    Processing Fee: A processing fee is a charge by the lender for clerical items associated with the loan. Examples of processing include loan set up, organization of loan conditions for underwriting, and preparing required disclosures for the borrower.
    Underwriting Fee More Info
    Underwriting Fee: A fee charged by the lender to verify information on the loan application, authenticate the property’s value, and perform a risk analysis on the overall loan package.
    Wire Transfer Fee More Info
    Wire Transfer Fee: In most cases lenders wire funds to escrow companies to fund a loan. Commercial banks that perform this function will charge the lender so the fee is generally passed on to the borrower.
    (If Any)
    FHA Upfront Premium More Info
    FHA Upfront Premium: A fee paid in cash at the close of escrow or more commonly it is financed into the loan. These premiums are pooled together by the FHA and are used to insure the risk of borrower default on FHA loans. FHA upfront premiums are prorated over a five year period, meaning should the homeowner refinance or sell during the first five years of the loan, they are entitled to a partial refund of the FHA upfront premium paid at loan inception.
    (If any)
    VA funding Fee (If any)
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    Other Fees More Info

    Other fees could be either additional Administrative Fees that a lender charges or it could be a Flat Fee to cover all lender charges such as: (Origination Fees, Points, Underwriting and Processing Fees, Credit Reports and Tax Service Fees)

    The flat fee does not include prepaid items and third party costs such as appraisal fees, recording fees, prepaid interest, property & transfer taxes, homeowners insurance, borrower’s attorney’s fees, private mortgage insurance premiums (if applicable), survey costs, title insurance and related services.

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    Current Mortgage Rates as of November 21, 2018
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    Data provided by Informa Research Services. Payments do not include amounts for taxes and insurance premiums. The actual payment obligation will be greater if taxes and insurance are included. Click here for more information on rates and product details.
  • Construction Loan Qualification Requirements
  • The qualification requirements for a construction loan are different than for a standard mortgage and include significantly more documentation, as you would expect.  Lenders require that borrowers submit a detailed plan and schedule for the new property construction or renovation.  Borrowers may be required to submit foundation reports, property surveys, engineering studies and architectural plans.  In many cases borrowers are required to re-submit reports and surveys upon completion of the project to verify proper construction.

    Borrowers typically are required to work with a licensed contractor or builder who is approved by the lender.  The lender may require the contractor to sign the loan agreement that outlines the key construction mortgage terms including the schedule of disbursements.  Given how construction loans work it is crucial that the borrower, lender and contractor are in total coordination on the budget and time frame for the project.  Making sure that the contractor and other third parties are paid on time helps keep the project on track.

    The lender also reviews the construction plans to make sure that you are budgeting sufficient funds to complete the project. The last thing the lender wants is to provide a construction loan that does not cover the full project cost. Most lenders also require borrowers to add a buffer or cushion to the loan amount to account for unexpected costs. Building a home or making major renovations almost always takes longer and costs more money than anticipated.  Adding the buffer to the construction loan helps ensure that project is completed according to plan.

  • Great Mortgage IdeaWhen budgeting construction or renovation costs, borrowers should build-in a 10% - 15% cushion to account for cost overruns and unplanned expenses
  • Borrowers are also required to meet the lender’s qualification guidelines including credit score and debt-to-income ratio requirements.  Lenders want to make sure that you can afford the construction loan payment, especially because you usually do not live in the property while it is being built which means you have an additional housing expense.  Borrowers should make sure they understand the lender's qualification requirements before applying for the loan.  

    Use our mortgage quote feature to review free, no-obligation quotes from leading lenders.  Our quote form is easy-to-use, requires minimal personal information and does not affect your credit.  Comparing multiple loan proposals is the best way to save money on your mortgage.

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  • Construction Loan Property Eligibility
  • Owner-occupied primary residences and vacation properties are eligible for construction loans. Most lenders do not offer construction programs for investment properties and properties you intend to sell instead of live in require a different type of mortgage. Many lenders also require the property financed to be a detached, single-unit residence.

  • Great Mortgage IdeaRelated FREEandCLEAR Resources

  • Sources

    Construction Loans: https://www.fanniemae.com/singlefamily/construction

About the author

Michael Jensen, Mortgage and Finance Guru

Michael is the co-founder of FREEandCLEAR. Michael possesses extensive knowledge about mortgages and finance and has been writing about mortgages for nearly a decade. His work has been featured in leading national and industry publications. More about Michael

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