| How construction loans work
Can you explain how construction
loans work? Why is it so difficult to find construction loan
information on the Web?
Construction loans are story loans. That means that
the lender has to know the story behind the planned construction
before they're willing to loan you money. Because it's a story loan,
it's not going to be standardized like mortgage loans underwritten
to Freddie Mac or Fannie Mae guidelines. That said, there are some
common features to a construction loan. Construction loans typically
require interest-only payments during construction and become due
upon completion. Completion for homeowners means that the house
has its certificate of occupancy.
Construction loans are usually
variable-rate loans priced at a spread
to the prime
rate or some other short-term interest
rate. You, the contractor and the lender
establish a draw schedule based on stages
of construction, and interest is charged
on the amount of money disbursed to date.
Another variable in construction loans is how much
of the project cost the lender is willing to lend. If you already
own the land, then that can be considered as equity on the construction
Many homeowners use construction-to-permanent
financing programs where the construction loan is converted to a
mortgage loan after the certificate of occupancy is issued. The
advantage is that you only have to have one application and one
Depending on your view on interest rate trends,
you could also purchase a rate-lock
agreement valid through the expected completion of the construction.
Just make sure you allow for the inevitable construction delays.
A construction loan, unlike a mortgage, isn't
meant to be around for a long time. If you're taking out a $200,000
construction loan for six months and you pay an extra 0.5 percent
on the loan, it costs you an additional $250. (Assumes an average
$100,000 loan balance over a six-month construction period.)
You may be willing to pay a higher rate on the
construction loan if you're doing construction-to-permanent financing
and can get better mortgage terms or a longer, better rate lock
from that lender.