by Charlene

Created on: September 14, 2008

A construction loan is a short term line of credit used to pay for the materials and labor that is required to build a home or other real estate project. It is very different from other mortgage loans that you may be aware of.

Construction loans involve determining the value of real estate that is not yet constructed. Because construction loans do not have the strength of the collateral, the lender must rely more heavily on the strength of the borrower and the builder/ General Contractor. The borrower or General Contractor must have development expertise and experience.

In order to assist eh lender in determining the future value of the construction project, information must be provided on the planned improvements, and what materials will be used to calculate the total costs to complete the construction.

Lenders require and review the following before they approve a construction loan:

A construction contract which is an agreement between the General Contractor and borrower that details the planned construction project, the amount of time required to build the home and the agreed upon cost;

A completed loan budget worksheet, which brings all the costs together, along with the items that the borrower has paid for in advance. This will be used to determine the maximum loan amount and the amount of equity or cash to close required by the borrower;

A detailed cost breakdown, prepared by the General Contractor, which includes the hard and soft costs of the project. Soft costs include permit fees, engineering fees, architectural fees, and other costs associated with building but are not part of the actual construction costs. Hard costs are referred to as the actual cost of construction, covering all materials and labor associated with building;

Plans and specification, which include a set of building plans which should include a detailed floor plan, that have been prepared by an architect and approved through city or county planning;
A Builders statement which includes the details their building experience, and track record which will show that they are capable of performing the terms of the contract;

The General Contractors license, however not all states require one;

After the lender has reviewed and approved your loan, you will find that construction loans are shorter term notes ( usually between 12- 18 months) that carry a higher interest rate and are often variable rate as opposed to a fixed rate note.

Some new construction loans require you to make interest only payments during the construction phase, but most offer an interest reserve included in the loan amount an interest reserve is an account that is established to pay the estimated interest costs during the construction. This way you do not have to make out of pocket payments during the construction. It is important to note that if the interest reserve is depleted during construction, you will have to make interest payments.

In order to get your projected started, lenders typically disperse 5 % of the construction hard costs and funds for some of the upfront costs such as permits. A subsequent disbursement is made when the project is 10% completed. Keep in mind that each lender has their own set of rules for taking a draw against the account, but the disbursement of funds are handled either by a title company or settlement attorney.

A construction loan is structured to come due when the home or project is complete, and you will be required to refinance into permanent financing when the construction period is over and usually the bank will rollover most of your original costs into your new loan. Some lenders offer construction to permanent financing programs that can convert to a fixed rate mortgage.

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