Construction Loan Information - Vanta Commercial LendingThe Construction Loan Defined
A construction loan is a type of short-term loan intended to help finance a real estate project like the building of a new home. A construction loan can bridge the gap between building expenses and long-term financing. It is usually taken out by a professional builder or a home buyer. Due to increased levels of risk, most lenders impose higher interest rates on construction loans than they do on mortgages.
The Construction Loan Process
The most common borrowers who take out construction loans are contractors and property owners who are building a custom home. The most common term for a construction loan is just one year. Borrowers typically seek new financing to pay off a construction loan after their building project is complete. This new financing may take the form of a general loan (referred to as an “end loan” in this context) or a traditional mortgage. Some lenders charge only interest payments on a construction loan for the duration of the building project. Some construction loans are structured so that the borrower must pay off the balance fully by the end of the project.
When a property owner takes out a construction loan, lenders often structure the loan so that funds are sent directly from the lender to the contractor. Loan payments are typically sized and scheduled to fit the stages of the construction project. Construction loans can be used to finance restoration and expansion projects as well as the construction of a new home.
Unique Features Of Construction Loans
Lenders often require a large down payment for a construction loan. 20 percent is typical, and some lenders require as much as 25 percent. Securing a construction loan can be difficult for borrowers with a limited credit history. Offering collateral is often difficult for construction loan borrowers, as their most significant asset, their home, is not yet built. Lenders will expect to review in-depth construction details (a set of documentation called a “blue book”) before approving a construction loan. The borrower will also need to prove that there is a qualified contractor or construction firm attached to the project.
The lenders that usually make construction loans are local banks and credit unions. Their greater familiarity with regional housing markets enables them to accurately assess the risks posed by a given construction proposal.
Owner-Builder Construction Loans
An ordinary construction loan is usually difficult or impossible to secure if the borrower intends to act as the contractor or builder on his or her project. Lenders accommodate such borrowers with a specialized variant called an owner-builder construction loan. Qualifying for an owner-builder loan is a complex process. In addition to the comprehensive construction details described above, a potential borrower also needs to be able to convincingly prove their ability to carry out the construction work properly. Borrowers taking an owner-builder construction loan should (and may be required to) add a contingency fund to their budget to cover unexpected expenses.
A Sample Construction Loan
Borrower Jane Doe prices out the new home she wants to build and determines it will cost $500,000. She secures a one-year construction loan for that amount from her local bank. She and her loan officer build a drawdown schedule that accommodates her plans for the project.
Costs in the first month of construction amount to only $40,000. Jane draws only that amount from her bank. For that first month, her repayment obligation is merely the interest on the $40,000. As Jane’s interest covers only the amount she draws instead of the full sum of $500,000, she saves significantly throughout the construction project.
Jane’s house is completed by the time the loan term ends. She works with her local bank again, refinancing the amount she has borrowed and converting her debt into a standard mortgage.