What is a Construction Loan?

Location is a top factor in the value for a home. You purchased a parcel of land. You have hired an architect, engineer and builder and the blueprints are ready for the next stage of building. How do you fund the building of the home? What kind of loan is available for building a home from scratch? Is a construction loan more expensive than a standard mortgage loan of a preexisting home?

You can apply for a construction loan from financial lending institutions such as banks, private lenders and insurance companies.

Loan maturity

A construction loan is unique, specialty type of loan. A construction loan is considered a short-term loan and varies from a standard mortgage loan. The terms of the length are the primary difference. Construction loans are typically paid back in full within in an agreed number of years and not a span of 15 or 30 years like a typical mortgage for a pre-existing home. Construction loan duration is usually geared to be repaid when the construction period is completed. The funds are released by a draw schedule. A draw schedule calls for certain items to be completed before funds can be released to the builder.

Loan choices

Construction loans have varying features for homeowners seeking a short-term loan. The main feature a homeowner should seek in a construction loan is the roll over feature at the end of the building phase. The roll over feature allows the homeowner to transfer the construction loan to a regular standard mortgage without paying costly closing costs for a second time. The avoidance of double closing costs is usually when the homeowner applies for a construction loan directly. The choices for construction loans and features of roll over will be contingent upon the lender. The lender evaluates each construction project for the possible merit and investment the home will yield. 

Loan conditions

Construction loans are offered by most lending institutions. Criteria for loan approval, as with standard mortgage applications, are strictly reviewed for risk. Construction loans are chiefly short-term loans. The only interest option is variable rate loans. Construction loans are contracted for short-term duration and involve straight interest payments. The loan is due and payable upon completion of the construction of the home. Once interest payments are due, they will be payable every month until the construction is finished.

Building your dream home

Building a dream home from scratch, blueprints and designers may be the path of homeownership chosen. Funding the home building will require a construction loan from a bank. The loan is considered a short-term loan and is more expensive than a long term loan due to interest-only payments during the phase of building. A construction loan is processed in a similar way to a standard loan, with closing costs and reviews. Try to compare the features available to you when applying for a construction loan.

Construction Loans:

One-time close construction loan, a one-time close with a note modification, and a two-close construction loan. The next few paragraphs should give you a good idea of what’s out there, and provide you with the knowledge to ask the right questions and stay on top of the game.

One-Time Close Construction Loan

A one-time close, also called an “all in one” construction loan, is a fairly simple way to go about building your home. This type of loan offers a single close, and a single rate for both the construction term and the end financing (we’ll touch on the rate later). Typically, these loans allow for a maximum 12 month construction term, and may have penalties for going over. Once the loan is settled construction may begin. You’ll be asked to pay either interest on the money that has been disbursed to the builder, or a regular mortgage payment. This varies from lender to lender so be sure and ask what your options are before you get to far along. The funds are released either by a draw schedule, or a generic punch list. A draw schedule calls for certain items to be completed before funds can be released to the builder. This is different than a punch list because the list allows greater flexibility because different items are sometimes completed at different times, depending on what materials are currently available to the builder. As your home nears completion, you’ll need to consider your final rate. At the settlement, you may have been given the options to either lock or float your rate. If your rate has been locked, you may have the ability to float down for a cost, typically one percentage point of the loan amount. If you chose to float your rate, you’ll need to contact the bank about agreeing on and securing the final note rate. Once your rate is decided upon, and your home is completed, your note will automatically convert to a 29 year mortgage. The loan will be 29 years because one year was used during the construction period.

Note Modification Construction Loan

The second option to finance your new home is a construction loan with a note modification. This loan looks a lot like the previous loan, but with a few unique features. The first difference to address is that there are often two separate rates. The first rate covers the construction term (often based on prime), and the second rate is the end loan rate. The construction rate is typically fixed during the construction term, and you’ll be asked to pay interest on the amount that is disbursed based on that rate. As construction progresses, your payment will increase accordingly. The end loan rate can either be locked, or left to float with the market. That decision is up to you. When discussing the end loan there are a few important points to note. First and foremost, find out how long your rate will be locked for. Often times, the rate can be locked for as long as nine months, or as short as three months. Be sure and allow enough time to get your house completed, and build in a cushion should and unforeseen issues arise. The second point to note is whether or not there is a float down option, and what it will cost. If you decided to lock your rate and mortgage rates fall during construction, you need to make sure that you have the ability to reduce your rate without refinancing after your home is completed. Moving forward, now that we’ve decided our rate terms we can get to building. As I mentioned before, you’ll be paying interest on the money that is disbursed throughout the construction term until your house is complete. Once your house is complete, it is time to modify your construction loan. Modification is simply the process of converting your construction loan into a permanent mortgage. While there may be costs associated with this, they won’t be nearly as much as a second settlement. Typically, the costs that are incurred during modification are to establish your escrow accounts and pay for any outstanding interest or other fees that may have accumulated during construction.

Two-Time Close Construction Loan

The third, and final type of construction loan that I’ll discuss is a two-time close construction loan. This loan is just as it sounds, there is one closing at the start of construction and a second closing to refinance the construction loan into a permanent mortgage. Upon closing on your construction loan you’ll begin making interest only payments to the lender, and just as before these payments will increase as construction progresses. Once your home is completed, you’ll need to refinance your construction loan into a permanent mortgage. The costs will be greater for this type of construction loan, but there is a little more flexibility that goes with it. Generally, you’ll be able to get a lower rate on your permanent mortgage because you’ll be working with a true refinance rate, not the rate based on a construction to perm loan. Another thought to take into consideration is that you won’t be locked into an end loan amount. This is important to consider in case you have any cost over runs or upgrades.

So whether you chose a one close, a one close with a modification, or a two close, make sure that you have all of your bases covered and plan for surprises.
Other questions to consider when speaking with your lender:

Type Of LoanQuestion
One close/modificationDo you have a house to sell? If so, can you reduce your end loan amount when you sell that house?
One close/modificationWhat happens if my construction cost runs over my loan amount?
Two CloseWhat happens if my end loan falls through and I can't get approved again?
One close/modification/two closeIs there a builder approval process? If so, how long does it take?
One close/modification/two closeWho are the draw checks made out and sent to?

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