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6 Questions and Answers About Construction Loans

Although there are lots of beautiful homes to choose from - and in many price ranges - you may be finding the ones in your desired locationaren't quite what you had in mind?

If this sounds like you, a construction loan can provide you with the funds you need to make the house of your dreams into reality.

There are many elements to a construction loan to consider before you put pen to paper, shovel to dirt and hammer to nail.

Here is a little bit more about construction loans that can help you dig into the details.

1. What is a construction loan all about?

Perhaps the best way to describe how a construction loan works is how the average home is built: It's put together pieces at a time, starting with the foundation, then the framing, clapboards and so on.

Unlike a purchase loan, in which the seller receives a lump sum from the lender, with a construction loan, the developer receives the funds to pay for the parts and labor over time in installments or "draws." Paying out the funds in stages - rather than all at once - provides greater clarity and assurance that production and progress is taking place on an ongoing basis. 

In addition to the proceeds of a construction loan paying for the cost of building and development, the funds also go toward the purchase of the land, assuming that the land isn't already owned by the borrower.

In terms of when or how these funds get distributed, much of this depends on the lender's arrangements with the builder and homeowner. Generally speaking, though, it is contingent upon progress and hitting benchmarks. In other words, if the builder requests more funds, the lender will send someone out to assure that work is complete. If things are going as planned, the added funds are released.

2. How much can you borrow with a construction loan?

From a total acquisition perspective - meaning the cost of land in combination with the expenses associated with development - some lenders can provide loans for up to 95% of the purchase price.

However, just because a lender can lend as much as 95% doesn't mean it actually will. The actual amount is largely contingent on the borrower's creditworthiness as well as the project's market value upon completion. A larger down payment may be required, equivalent to 20% or 25% of the price, for instance.

3. What type of construction loans are there?

Construction loans come in many different types or offerings. The one that most people think of are called construction-to-permanent. Much like its name suggests, a construction-to-permanent loan provides the funds necessary to build the home as well as the permanent mortgage financing once the home is complete. Occupancy for a construction-to-permanent loan is primarily for owner occupied residences. Construction loans are taken out assuming that the home will be the primary residence of the borrower. In some instances a vacation home or investment property requires additional considerations.

Other construction loan options include construction-only, FHA 203k, owner-builder and renovation loans. While a construction-to-permanent loan is for projects that are large in scale and scope - starting at the ground floor - a renovation loan is designed for projects that are much smaller in terms of work as well as actual financing. So if you're looking to refurbish your bathroom or kitchen, replace carpeted flooring with hardwood or add a second floor, a renovation would likely be a better option than a construction loan.

4. Can you take out a construction loan if you're the one doing the building?

In a do-it-yourself era, evidenced by DIY Network and HGTV - many people are looking to save money by doing the labor themselves. However, construction loans aren't for DIY enthusiasts.

Home construction projects are a huge undertaking and lenders must be certain that developers have the appropriate qualifications, certifications and licensure that corroborates their ability to complete the project on budget and on time. Thus, you'll need to find a builder to construct the house on your behalf. There may be some exceptions that apply. If you're in the industry as a general contractor, have the means and technical capability, you may be able to helm the project.

5. How does interest work on construction loans?

There isn't much of a difference between construction loans and regular purchase loans from an interest perspective. The interest that you pay is predicated on your credit history and what the market is for interest rates, which is influenced by the Federal Reserve. Rates can be fixed - where the interest remains the same for the life of the loan - or adjustable, which vary over time. Variable rates typically start out very low, which is why they remain highly popular.

As far as when you will start paying monthly mortgage payments with the attached interest, it all depends on when the project actually begins. Usually, it's while building is ongoing, rather than once the house is fully completed. At RMS the Borrower typically pays Interest-Only payments during the build phase, then switches to a fixed-rate, principal and interest, amortizing loan in the permanent phase.

6. What's the biggest distinction between a traditional loan and a construction loan?

As previously mentioned, a distinguishing characteristic of construction loans is how they're paid out, in phases rather than as a lump sum. They're also unique in that they’re on the shorter side when it comes to payment period. Typically, purchase loans run for around 30-years, which is the amount of time you have to pay them off. Construction loans aren't nearly as long. This is definitely something you'll want to keep in mind prior to applying, as once the project is completed, the balance of the cost will be due.

If the houses up for sale in your area simply won't do, a construction loan can make your homeownership dreams come true. Contact RMS to learn more.