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Construction Loans

Construction loans are a type of loan that provides funds for building a residential home, from purchasing the land to finishing the structure. There are two common types of construction loans – standalone construction loans, which only finance the building phase, and construction-to-permanent loans, which convert into a mortgage once the construction is completed. The borrower may need a separate mortgage to pay off the standalone construction loan.

To obtain a construction loan, borrowers typically need to pay a minimum of 20% down payment. The funds from the loan can cover costs such as the land, contractor labor, building materials, and permits. Since construction loans work on a short timetable and depend on the project’s progress, the borrower or their general contractor must provide the lender with a realistic budget, detailed plans, and a construction timeline. Based on these factors, the lender will release funds at various phases of the project, usually directly to the contractor.

Construction loans differ from traditional mortgages in several ways. Unlike mortgages that provide funds in a lump-sum payment, the lender pays out the money for a construction loan in stages as work on the new home progresses. During the construction phase, the borrower is only responsible for paying interest on any funds drawn to date until the construction is completed. The lender has an appraiser or inspector check the house during the various construction stages and makes additional payments to the contractor, known as draws, as the work is approved. Expect to have between four and six inspections to monitor the progress.

Different types of construction loans are available to suit various financial needs. One type of construction loan is the construction-to-permanent loan, where the borrower borrows money to build a home, and once complete, the loan is converted to a permanent mortgage. With a fixed-rate or adjustable-rate mortgage, the borrower starts making payments that cover interest and the principal. During the construction loan phase, the lender disburses the funds based upon the percentage of the project completed, and the borrower is only responsible for paying interest on the money drawn.

While many construction loans are conventional loans entirely privately originated and financed, there are government versions as well. FHA construction-to-permanent loans have less-stringent approval standards that can be helpful for some borrowers, or a VA construction loan is available for eligible veterans.

Another type of construction loan is the construction-only loan, where the borrower pays the loan in full at maturity, which is typically one year or less. The borrower can settle the debt either in cash or by obtaining a mortgage to pay it off. Construction-only loans can be more expensive than their construction-to-permanent cousins, especially if the borrower has to finance the repayment. That’s because the borrower completes two separate loan transactions and pays two sets of fees. To avoid another set of closing costs, it helps to shop for a mortgage.

For existing homes, borrowers can compare home renovation loan options. These come in a variety of forms depending on the amount of money spent on the project.

Another type of construction loan is the owner-builder construction loan, where the borrower acts as the home builder. Most lenders won’t allow the borrower to act as their builder because of the complexity of constructing a home and the experience required to comply with building codes. Lenders typically only allow it if the borrower is a licensed builder by trade.

In summary, construction loans provide funds for building a home and come in different types to suit various financial needs. They require a minimum of 20% down payment, and the funds are released in stages as the work progresses. Since these loans are unique, it’s crucial to conduct thorough research to determine the most suitable type of loan for your specific needs.