How Do Construction Loans Work?

Construction loans are more then a game of numbers. The lender wants to know the story behind the planned construction before they're willing to loan you the money. Because it's a special loan with a story, it's not going to be standardized like mortgage loans underwritten to Freddie Mac or Fannie Mae guidelines.

However, there are some common features to construction loans. Construction loans typically require interest-only payments during the construction period and become due upon the completion of construction. Completion for homeowners means that the house has passed all of the necessary inspections and has its certificate of occupancy.

Construction loans are usually variable-rate loans priced at a spread to the prime rate or some other short-term interest rate. You, together with the builder/contractor and the lender, establish a draw schedule based on the stages of construction, and interest is charged on the amount of money disbursed to date.

Another variable in any construction loan is LTV (Loan-to-Value ratio): how much of the project cost the lender is willing to lend. If you already own the land, that can be considered as equity on the construction loan.

Some homeowners like to use construction-to-permanent financing programs where the construction loan is converted to a mortgage loan after the certificate of occupancy is issued. The advantage is that you only have to have one application and one closing. The disadvantages are: delay in construction, possible running over budget cost, etc. With this type of deal you have less flexibility and have to have some money down and, possibly, money to close. We have had very good luck with regular construction loans and subsequent permanent financing. Please feel free to ask us about it.

It's a good idea to find out how much each day of the loan will cost you: it will motivate you to be more active in the participation of the management of your construction project. Typically, the Lender will charge an interest rate on the loan. You have to pay quarterly the interest on the money you have borrowed to-date. Let's say it is $123,000. That means that your quarterly payment is going to be $652.58 x 3mo = $1,957.50. Thus, one day of construction is costing you $21.75. Next time your total draws will be, let’s say, $216,000. It will bring your one day of construction cost to $36.00 and quarterly payment will be $3,240.00.

Any time you have any questions do not hesitate to ask us. Remember: there are no stupid questions. Nobody expects of you to know it all; after all, this is new to you and that is what we do every day. We will gladly help you achieve your dream. 

Frequently Asked Questions