Construction Loan Basics

Posted December 19, 2008 03:44 by Robert

Tags: financing

If you are thinking about building a house, you are going to have to find a lender who does construction loans, which are a bit more complicated than a traditional 15 or 30 year type mortgages. The way these loans work is that you present the bank with plans and they get an appraisal of the completed value of the project to help figure out what they will lend you.  

In almost all cases, you are going to have to put 20% down and maintain 20% throughout the project. The bank will usually give you an initial distribution to cover the purchase of the property and you will make you initial 20% down payment at that time. Your rate is locked in at the beginning of the loan and you typically have a year to finish the project. While you are in the construction phase, the loan acts like an equity line and you only pay the interest due on the actual balance each month so you are actually getting a one year rate lock. Then at the end, the total balance is converted into a traditional loan for whatever product that you chose (i.e. 5/1 ARM, 15 Year Fixed, 30 Year Fixed) and you being making normal principal and interest payments.

During the project, as you reach pre-determined milestones (which are set-up with the builder), the bank  releases the funds to your checking account (after a drive by inspection) for up to 80% of each stage, so that you are always keeping your 20% equity. The really nice thing about this is that the builder cannot come asking you for money without having completed the milestone, so the bank is essentially the bad guy. This is really a great feature and is more attractive than some construction loans which distribute all the money all upfront (mostly so they can charge the interest). Some banks will even do a title check before each disbursement to make sure that no subcontractors have placed liens for unpaid work on the property. In most cases, you don’t have to use all the money that you were approved for, your final loan will just be based on how much you actually used. 

Another important factor to consider. Given that you are going to be required to have 20% of the completed value of the home, you likely have this money sitting in the bank. It doesn’t make a whole lot of sense to pay interest on distributed funds and receive almost no interest on the money in the bank, so you might want to put all your equity in up front by making the few first payments yourself to the builder. This will put off increasing your loan balance and then as you get towards the end, you will be well above the 20% and the bank will be making all the payments.  However, some people do like to take a little bit from the bank at each stage just to have them do their due diligence.

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