Construction Loans

Taking out a loan for a home construction project is different from taking out a loan for a home mortgage or even for a business purpose. A person who needs a construction loan should understand the different types of loans that are available as well as the various legal issues that may arise.

A construction loan is a short-term loan that supplies the funds to custom build a home. A mortgage is for the purpose of buying an existing home. Construction lending is a special type of financing for the purpose of making construction possible. Once construction of the home is complete, the buyer must apply for a mortgage to finance the purchase of the home.

There are a number of different types of loans that qualify as construction loans. The first thing a borrower needs to consider is which one is the right one for their purpose.

A construction-only loan is a short-term loan that is usually expected to last for a year. It is intended to cover only the actual construction period. They are considered to be higher-risk than are other types of loan, because there are so many factors that can affect the timing and ultimate success of the construction project. These factors include the cooperation of the builder, getting permits and approvals from local city or county authorities and the like. Any of these factors might prolong the life of the loan beyond the timeframe desired by the lender.

This means that borrowers have a tougher time qualifying for a construction-only loan. Also, the interest rate is likely to be higher than for other kinds of loans. If a person decides to go with a construction only loan, they have to pay a second set of loan fees when they apply for a traditional mortgage at the end of the construction phase.

Another option is the construction-to-permanent loans. As with construction-only loans construction-to-permanent loans are one-time loans that fund construction and then convert into a permanent mortgage. During the construction phase, the borrower only has to pay the interest that accrues. While this sounds convenient, construction-to-permanent loans can be much more expensive than traditional mortgage loans.

If a person is an active-duty member of one of the armed services or a veteran, a person might qualify for a Veterans’ Administration construction loan.

Another option is a renovation loan. These are available to renovate existing structures and are insured by the Federal Housing Administration (FHA). A renovation loan allows borrowers to purchase and then renovate their new home while still making one monthly payment to their lender. Conventional loan borrowers may qualify for these loans through Fannie Mae, through its HomeStyle Renovation loan program, and Freddie Mac, through its CHOICE Renovation loan program which gives borrowers the ability to buy and fix up homes with only one loan, not two. Not all lenders offer these kinds of loans.

Another option is a cash-out refinance, which is another way to finance renovations of a home that person already owns. With a cash-out refinance, a person gets a loan secured by the equity in their home. The amount of the loan would be added to the principal of a new mortgage.

Another option is a straight home equity loan or a home equity line of credit. These would all be options for financing renovations.

Usually when a person builds a home, they hire a general contractor who manages the operation. They hire subcontractors who perform parts of the construction, e.g. a roofer, tile worker, plumber, electrician and the like. The general coordinates all of these subs so that the work flows efficiently and the project is completed according to schedule and the budget.

However, some prospective homeowners wish to act as their own general contractor. There are banks that offer owner-builder loans for this purpose. The lender is going to require the owner-builder to demonstrate that they have the expertise and licensing needed to complete a home construction project of this nature.

An end loan is a traditional mortgage loan for which a homebuyer or owner-builder can apply when a new home construction is completed. A person can get an end loan if construction is complete on the home. One good feature of an end loan is that the mortgage application for a newly constructed home is the same as it is for any other home.

What Are Story Loans?

Construction loans are so-called “story loans,” which means that the potential lender wants to hear the story about the plan for the construction project before they lend the money. Of course, as in all types of lending, a lender wants to ensure that the borrower will be able to pay the loan back, either through revenue earned from the construction project or by other means.

The “story” the lender wants to hear is the plan about how the loan is going to be repaid and what is going to happen to the project when construction has been finished.

What Are Contingency Funds?

A construction loan will often contain “contingency” funds that buffer the loan amount in the event construction ends up costing more than expected. Construction projects are notorious for cost overruns. A contingency fund is a kind of reserve fund set aside to handle unexpected costs that exceed budgeted amounts. If the borrower ends up not needing the extra funds, they can simply be removed from the loan amount.

What Are Locked or Floating Interest Rates?

On some occasions, a person would have the opportunity to negotiate either a locked interest rate or a floating interest rate. As the name suggests, a locked interest rate does not change over the course of the loan. A floating interest rate may rise or fall with the market. Which one would be the better choice depends on the circumstances at the time the loan is made.

General economic circumstances may suggest that interest rates are going up. In order to avoid increases in the interest rate on the loan, a person might want to get a fixed rate. On the other hand, general economic conditions may suggest that interest rates are on the decrease, so negotiating a floating rate might be the better choice.

What Role Does the Interest Reserve Amount Play?

During the course of the construction, the borrower is only expected to make interest payments on the loan. These payments can be made from an “interest reserve.” An interest reserve is an amount that can be added on to the initial loan to make payments on interest while the construction project is under way.

Thus, the borrower does not need extra capital for interest payments until the construction is complete. The reserve amount is usually equal to the interest that accrues on the loan during the construction period.

Can a Construction Loan Be Changed to Permanent Financing?

In some cases, banks will allow construction loans to be changed into a permanent financing mortgage loan when the construction is complete.

For example, the construction project may be to build a new primary residence for the borrower. The person may expect it to take some time to pay off the loan, as it does with most mortgage loans, which have a life of 30 years. In this case moving from construction to permanent financing would be a good option.

Do I Need a Lawyer for Help with a Construction Loan?

Before taking out a construction loan, it is always helpful to shop around at different lending institutions to see what loan terms and interest rates are offered. Different lending institutions may offer different interest rates, options for payment and other important terms.

In addition, before signing a lengthy and technical construction contract loan agreement, it would be wise to consult a business attorney to ensure that your rights are fully protected in the contract and that it does not give an unfair advantage to the lending institution.