A type of loan which is not commonly known is a construction loan. If you have opted to build your own home rather than buying an existing property, you may not be aware that you won’t be getting a traditional mortgage for this. In place of a mortgage, you are likely to get a construction loan. If you are not sure what a construction loan is, how they work and what it can provide you with, this guide aims to clear that all up. We will also be looking at some pros and cons of either.
Construction loans are also provided for businesses (though if you’re selling a business through a business broker you might to consult with them about having a loan on your books at the point of sale”).
What is a construction loan?
Construction loans are high-interest, short-term loans which ae used in order to cover the cost of building or rehabilitating your home. A traditional home loan is based on the fair market value of the property and determined by the property’s condition. In contrast, a construction loan is based on what the projected value of the property once the work is complete.
Types of construction loans
There are actually three different construction loans which you can choose from.
This kind of construction loan is perfect if you have definite construction plans and timelines in place. With this loan, the bank will pay the builder as the work is being completed. Afterwards, the cost will be converted into a normal mortgage. You are allowed to lock interest rates at closing, which makes way for steady payments.
These must be paid off in full once the building of your new home is complete. It is a good choice if you have a larger budget to work with or you are confident in the sale of your current home holding a lot of promising cash value to cover another build. You will not receive a converted mortgage and to get this, you will have to find your own lender and be approved for the second time.
Renovation Construction loans
With this, you will be using it if you are buying a fixer-upper rather than a lott of land to build on. Government programs are in place to make any renovations you plan on doing to the property part of the mortgage, along with the actual purchase price.
How do construction loans work?
More traditional loans will be paid out by a mortgage company in order to cover the costs of the property in one lump-sum upon closing. However, construction loans work very differently in that they will be paid out in instalments. The bank will pay the builder throughout various phases of the construction. The total cost will then be transferred to you once the entire project is complete.
Each instalment is called a “draw”. The way it works is that each draw will reimburse the builder for the costs which are needed to cover that phase of building. This means that you do not have to rely on your own funds to pay for these up front. Before each draw is approved and sent, the bank will do an inspection in order to verify the estimated cost of the current phase of building as well as who well the project is moving along. Therefore, it is vital that you work with a good builder. You will need to seek out someone who is experienced with scheduling and budgeting as well as having the ability to work well within those limitations.
Benefits of Construction Loans
Choosing a construction loan over a traditional one has a number of benefits, including:
- They are interest-only during constructions
- They have fairly flexible terms
- The added scrutiny provides a good structure
Disadvantages of a Construction Loans
Like with any type of loan, there are also disadvantages:
- They are much harder to qualify for
- They do have higher interest rates
- Shorter-term loans can be perceived as a risk