Construction Loan

 A term used for building a new home or another related real estate project.

Author: Manu Lakshmanan
Manu Lakshmanan
Manu Lakshmanan
Management Consulting | Strategy & Operations

Prior to accepting a position as the Director of Operations Strategy at DJO Global, Manu was a management consultant with McKinsey & Company in Houston. He served clients, including presenting directly to C-level executives, in digital, strategy, M&A, and operations projects.

Manu holds a PHD in Biomedical Engineering from Duke University and a BA in Physics from Cornell University.

Reviewed By: Elliot Meade
Elliot Meade
Elliot Meade
Private Equity | Investment Banking

Elliot currently works as a Private Equity Associate at Greenridge Investment Partners, a middle market fund based in Austin, TX. He was previously an Analyst in Piper Jaffray's Leveraged Finance group, working across all industry verticals on LBOs, acquisition financings, refinancings, and recapitalizations. Prior to Piper Jaffray, he spent 2 years at Citi in the Leveraged Finance Credit Portfolio group focused on origination and ongoing credit monitoring of outstanding loans and was also a member of the Columbia recruiting committee for the Investment Banking Division for incoming summer and full-time analysts.

Elliot has a Bachelor of Arts in Business Management from Columbia University.

Last Updated:October 27, 2022

A construction loan is a term used for building a new home or another related real estate project. It covers all the expenses necessary to protect the project's costs before acquiring long-term funding. 

However, this type of loan has higher interest rates than many other traditional mortgage loans. A builder or home buyer takes out these loans to cover the project's costs before obtaining long-term funding.

These loans are considered relatively risky and are deemed to be short-term loans. These loans usually last for about one year. After the house is finished, the borrower may refinance the cons. loan into a permanent mortgage. 

By doing this, the borrower may pay off the loan. However, the borrower might only be required to make interest payments on a cons. loan while the project is still underway. Not all cons. loans are the same. 

Some cons. loans would require the balance to be paid off by its whole just before the project is done. 

To summarize, the cons. loans can allow borrowers to build the home they have always dreamed of. However, due to the risks involved, they have higher interest rates and larger down payments than other regular mortgages. 

Let us take an example to understand these loans. Steve decides that he can build his new house for $500,000 and secures a cons. loan for one year from the bank. The bank then prepares a  drawdown schedule for this loan. 

In the first month, only $50,000 is required to cover costs, so Steve takes that specific amount and pays interest only on that amount- saving money. After that, he continues to take funds as required by the drawdown schedule.

Types

There are two cons. loans during the construction phase. First, payments are interest-only and start-out small as you only pay funds that have been disbursed. The two types of cons. loans are:

1. Construction-Only Loan

Construction-only loans are not issued for a period exceeding one year. They are meant to cover the actual construction period. The majority of banks do not offer this type of loan since it is considered to be of high risk. 

They are harder to qualify for, and the interest rate will likely be higher than a traditional loan. In addition, for construction-only loans, you will have to pay a second set of loan fees when you apply for a conventional mortgage. 

2. Construction-to-Permanent Loan

They are considered to be a financing option for prospective home builders. Homebuilders may apply for these types of loans, but they are deemed one-time loans since they are converted into permanent mortgages.

During the construction phase, borrowers make interest payments only. As a result, construction-to-permanent loans are more expensive than traditional mortgages. 

3. Renovation Loans

Renovation loans are used for home renovation and are insured by the Federal Housing Administration (FHA). With this, the borrower to purchase and renovate their new home while still making a monthly payment to cover both costs. 

4. End Loans

End loans are much more like traditional mortgage loans that a home buyer or builder can apply for after the home is constructed. These may be offered by the majority of banks across the United States. 

You may get an end loan if the home's construction is complete. One benefit is that the mortgage application for a newly constructed home is the same as for any other home and is less complicated than traditional loans. 

What are the requirements? 

These loans require a lot of pre-planning before a bank lends them the cash. Essentially, you need to accomplish each of the following requirements to assure the lender that you can repay this loan shortly. 

1. A Qualified Builder and/or Construction Team 

To get an institution to get you approved for a cons. loan, you need to be a licensed builder with the documentation to prove it. In addition, many lenders will ask you to provide a report on your profits and losses.

To be a licensed builder, you must prove your reputation for building safe and enduring homes. If you plan to build the house yourself, finding a lender, such as a bank or another type of financial institution, will be extremely difficult. 

It's never a good idea to skip professional services and jeopardize your construction project.  

2. Detailed Description of the Construction Plan. 

There would not be a lender that would hand over a substantial amount of money for an unclear plan. Therefore, it is better to present the lender with your plan for the construction. 

To maintain a clear relationship with the lender, you must describe every detail of the constriction plan. These details are commonly referred to as a "blue book."

The "blue book" must include information on the general timeline of the project, floor plans, ceiling heights, what materials you will use, and what would be the cost of those materials. 

The blue book must also name suppliers and subcontractors involved in the project. 

3. Appraisal

Getting an appraisal for the construction plan is one of the main steps in getting a cons. loan. A licensed appraiser usually estimates a home's value. The lender must have an appraiser to give out a loan. 

The appraiser will be responsible for taking care of the calculations and measures using detailed information from the blue book. The appraiser must also assign value to the plot of the land on which the home is being built. 

The appraisers compare these calculations to similar projects and houses in different locations. They refer to these comparisons as "comps." Finally, they determine the value of the project. 

4. Sizable Down Payment

Since the amount of cons. loans provides excellent assistance for these types of projects, lenders or financial institutions will require a minimum of 20% down.  

This down payment helps ensure the lender that you, as a home builder, have a sincere interest in the project. In addition, lenders do not want borrowers to abandon the construction when things become problematic down the line. 

The final step in getting a cons. loan is the certainty of your ability to repay the loan. The lender will request to check your credit score and see proof of income. 

Two-Time-Close Construction Loans

A two-time-close cons. a loan separates two loans, a short-term loan during the construction phase and a permanent mortgage loan on a completed project. 

Essentially, you are refinancing the building when it is complete, and you will need to get approval and pay all of the closing costs again. 

However, during the construction phase, you will only pay interest on the money that has been paid out, so payments will be relatively small but will reimburse more money to you. 

Banks typically add a 10% contingency for home construction projects' cost overruns. In any circumstance, it is better to qualify for the highest amount possible. 

Due to two loan settlements, closing costs will be more significant for this type of loan. However, because you will be working with mortgage refinance rates, which are frequently more affordable than the rates offered in one-time-close loans, you will receive a better rate on the permanent mortgage.

In most circumstances, you will be free to shop around to ensure you obtain the best rate and terms for your cons. loans, but it may be simpler to go with the same lender for permanent or long-term financing. You will not be stuck into a fixed loan amount and can borrow more. 
 

The pros of a two-time-close cons. loan are

  • Greater flexibility to modify plans and increase the loan amount during a project
  • Compared to one-time-close loans, mortgage rates are frequently lower.
  • Typically, you have full reign to compare permanent financing options. 

The pros of a two-time-close cons. loan are

  • It needs approval two times.  
  • You risk altering your financial situation when asking for long-term or permanent financing.
  • If you do not get approved for permanent or long-term financing, you could face the possibility of a potential foreclosure. 

Frequently Asked Questions (FAQ's)

Researched and authored by Sergio Flores | LinkedIn

Reviewed and edited by Parul Gupta LinkedIn

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