A construction loan refers to a higher-interest, short-term loan that funds a residential construction project. In most cases, it’s a one-year loan that caters to the expenses of building a property. Most people use this financing to cater to the land acquisition cost, contractor labor, construction materials, and permits.
How it Works
Construction loans have variable rates. That means their rates can go up and down. These loans have higher rates than traditional mortgages. That’s because your home acts as collateral for a conventional mortgage. That means the lender will seize your residential property if you default on the traditional mortgage. However, a construction loan doesn’t give the lender an option. Therefore, the lender sees this loan as a high-risk option.
Since construction loans have a short payment duration and they depend on the project completion, the lender requires the borrower to provide a construction timeline, a realistic budget, and detailed plans.
Upon approval, you will provide a draw schedule or a draft that follows the construction stages for the project. What’s more, you will only make interest payments at the time of the construction stage. Additionally, the lender doesn’t give you a lump-sum amount. Instead, they pay money in stages, depending on the progress of the project. The borrower’s obligation to repay the interest for the drawn funds starts when they complete their construction.
The lender also sends an inspector or appraiser to check the construction project’s progress during different stages. And the lender pays more money to the contractor once the appraiser approves the progress.
The borrower can convert a construction loan into a traditional mortgage after building a home. However, this depends on the construction loan type. Nevertheless, a borrower can get a different mortgage to pay off their construction loan.
Final Thoughts
A construction loan is just that. It is a loan that a borrower takes to fund a construction project. The terms and conditions of this loan can differ from one lender to another. Therefore, take your time to understand the terms and interest rate before taking your construction loan.