Construction Loans

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A construction loan is a short-term loan that is used primarily for homeowners or real estate developers to build property if they do not have the proper capital to build it. Most of these loans last up to a year, and once the construction is completed, the debt must be repaid using an end loan, which often comes in the form of a long-term mortgage.

Eligibility

There is often a strict procedure that banks abide by when providing construction loans. A structure needs to be built, and the bank needs to be able to put trust in the person or company taking out the loan. It is possible that the construction is faulty or badly planned, causing the property value to plummet. Banks, then, will be looking for a builder that is reputable and qualified for the position. People who do contracting independently will have a lot trouble getting a construction loan.

Banks will also demand an extremely-specific list of materials, as well as a set of floor plans and blueprints. All of the information is usually provided in what is known in the industry as a “blue book”. After the plans are received, banks will get an appraiser to estimate the value of the house based on the floor plans, locations, and “comps”, different houses that have similar specifications.

Finally, banks will demand a hefty down payment to ensure that the investment is legitimate. The industry standard is approximately between 20-25%. This also gives the bank money in case the resulting value is lower than expected.

Happy young couple getting a loan for home construction

Specifics

Banks are very prudent when giving away construction loans. Instead of providing all of the money at once, they schedule “draws”, or funding in intervals. These are often based on completed steps in the development of the houses. The first draw is often the builder’s own money from the down payment, and the bank will often inspect the construction to make sure that things are going smoothly.

Once the construction is finished, then they can pay the end loan.

Construction loans also contain interest rates, but these are often variable rate loans, which means that the rate is wont to change based on market characteristics. In fact, construction loans are almost exclusive interest-only, meaning that interest is only paid on what has been borrowed, and not just the principal loan balance. Since it is incremented, interest only needs to be paid on the money that has been paid out. If the bank provides you with 10,000 of 100,000 dollars, then you pay interest on the 10,000 only.

Concerns

There is much risk involved in constructing a home and looking to get return on it, and both builders and banks are aware of this. It is possible that the home will not be built on time or on budget, for example. Fees from rental costs loan extensions can be extremely costly, especially if you are depending on the house being built to get return.

There is also a lot of risk caused by fluctuating markets or various internal and external factors that may lower the value. Internal factors include bad construction work, while rising crime rates may be a hindering external factor.

Finally, if major changes in your income have occurred, then you will not have enough credit or money to be qualified for an end loan. This is a major issue, as construction loans are impermanent and need to be paid off. And when you cannot pay that loan off, the bank may foreclose your home.