A construction loan is a loan used by the owner of a property or soon to be owner of a property where a new home will be constructed, or an existing home will be improved.  The loan is for the owner, not the builder, to use to pay for the home to be built or improved.

Just like “regular loans”, you can choose from a fixed rate or an adjustable rate mortgage (ARM) that is fixed for three, five, seven or ten years. 

The loan is a so-called “construction to perm” loan or “one-time close” loan.  This means you will use the loan for the construction phase and permanent phase after construction is complete (refi options are available – more on that later).  The loan is a 30 year or 15 year term loan with options of being a fixed rate or fixed term ARM.

There is one closing that takes place before construction begins. If you are purchasing the property, the closing would take place at the time you close on the land or property. You close on the construction loan upfront before you start construction.  There is no second closing once the project is complete.

If there is any down payment required for the loan, it goes in first before you start drawing loan funds.  As long as you stay within budget, all funds for the construction project will be pulled from the loan during the construction phase. If your budget increases during construction, you may have to make up the difference as items get paid out.

The payments on a construction loan are interest only during the construction phase based on the balance that you owe. The balance when you close will be relatively low and then as draws are taken on the loan for work completed, the balance and interest-only payments on the loan will increase.

Once construction is complete, the loan moves into the permanent phase and the payment changes from interest-only to principal and interest at the same program and interest rate. There is no second closing, and the loan does not balloon or come due. You simply start making regular principal and interest payments.

A construction loan can be used to build or improve your home.  It can be used for:

• Minor or major internal rehab
• Major addition and rehab
• Build a new home on land you own
• Tear down a home and build
• Buy a property or land and close on a construction loan simultaneously

The loan process for a construction loan is not much different than a “regular loan”. There are a few additional items that are needed that relate to the construction project and appraisal, but the process and qualifications are very similar. If you qualify for a non-construction loan, you should qualify for a construction loan for a similar amount.

Most clients will get started on the loan process when the plans and budget are nearing completion. This way, they can get the loan approval out of the way. Once the plans and budget are complete, the appraisal can be ordered. The appraisal for a new construction loan does take longer to complete – 15 to 20 days is a typical timeframe. Once the appraisal comes back, the client will most likely have a conditional loan approval subject to the appraisal and a few minor items. Once the appraisal and any other conditions get signed off, closing can be scheduled.

An initial call with the loan officer is the first step. During that conversation, you will discuss the basics of the loan program and what it means for your specific project. At the end of the call you should have a good understanding of how the program works, how much money you would potentially need for closing, what your payments would look like (both during and after the construction phase), and what the next steps would be.

Application

Closing

Once your loan is approved and any and all conditions have been cleared you can close your loan. You will need homeowner’s insurance. The insurance policy will vary depending on your project but may be a standard policy with construction coverage or a separate builder’s risk policy.

If you and your builder have agreed upon a deposit, that can be given at closing.

The construction phase begins after you close on your loan. It’s at this point your construction loan is in place and you can start drawing on it to complete your project. You will generally have 12-24 months to complete the project.

The most important thing to remember during the construction phase is that the loan will get paid out based on the original budget. If there are any increases in each line item, you will have to cover the increased cost dollar for dollar. This keeps the loan “in balance” with available funds to complete the project successfully.  There may be flexibility on this as long as the total budget amount doesn’t change.

The Draw Process

During the construction phase your builder will request draws for work completed or items installed. Funds will not be disbursed to pay for future work or working capital. A number of things occur during this process. Ideally, if the process is smooth the only item you will be aware of is signing your owner’s statement to authorize the draw once the due diligence has been completed.

Initiate

• The builder sends a sworn statement and other items to initiate the draw request.

• Bank orders an inspection to verify the items that are being requested to be paid on have been completed

Verify

• The builder’s sworn statement is reviewed for accuracy and completeness as well as other items needed from the builder such as lien waivers.

• Inspection takes place to verify that all items that are being requested to be paid have been completed or completed at the percentage requested.

Disburse Funds

• Homeowner signs an owner’s statement authorizing the draw.

• With completed paperwork and inspection report showing work complete, draw is funded.

Note: It is ultimately the homeowner’s responsibility to make sure the money that is being drawn from the loan and paid to the builder and contractors is accurate and reflects work complete. The homeowner has final control over the funds being drawn by signing (or not signing) the owner’s statement. Make sure you understand what the funds being drawn are being used for and that the amount is reflective of the work complete.