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How do Construction Loans Work?

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Most people are not very clear on the question; “How do construction loans work?” It all seems very complicated but the following facts may help clarify the concepts involved. Practically speaking a construction loan actually involves the need for two loans. The construction loan itself only covers the amount of time while the construction is occurring. The mortgage loan begins when the construction is complete. These two loans can and should be created at the same time, so that there is only one combined loan closing. Though there are other ways to do this, there are many financial advantages to closing both loans at the same time.

How do Construction Loans Work: Aspects of the Construction Loan

How do Construction Loans Work: Down Payment
Loans vary, but most construction loans require a down payment of about 30 percent of the value of the loan. FHA loans will take a much smaller down payment, and VA loans require no down payment at all. There is a reason for the down-payment, which protect the bank’s investment by insuring the owners are serious about completing the project. There have been incidents when no down payment was required, that owners walked away from the project, and left the bank and the contractor in a rather bad position.

How do Construction Loans Work: Escrow Account
When the construction loan is created, the money goes into a bank account, which the general contractor has a right to draw from as needed. If the owner is acting as the general contractor, and employing subcontractors, then the owner will be withdrawing from this account.

How do Construction Loans Work: Overages
The amount of the construction loan is usually the estimated price plus an additional 5 to 10 percent. If the extra money is not used, or if the cost proves to be less than the estimate, then the money is returned to the bank without interest.
Interest – Interest is only due for money spent from the escrow account. Only interest is charged during the construction period.

How do Construction Loans Work: Repayment
There is no repayment of any principle on the loan, until construction is complete. At completion, money from the mortgage loan repays the construction loan entirely, and any remaining money in the escrow bank account is returned to the bank without any interest owed.

How do Construction Loans Work: Aspects of the Mortgage Loan

How do Construction Loans Work: Amortization
A mortgage loan is an amortization loan. This means that each payment is equal, and each pays a little bit of the principal and a little bit of interest. This is a very complex idea for most people, but in the beginning most of your payment goes towards interest, because if all payments are equal, and the loan will eventually be paid, then the entire interest on the remaining money owed must be paid. In the beginning of the loan only a tiny percentage of your payment goes towards the balance. Any extra payments or additional money added to the payment will go towards the principle and that is why many people make extra payments on their mortgages. Extra payments can reduce the length of the loan and the total amount paid on the loan significantly.

How do Construction Loans Work: Term
Mortgage loans can be for either 15 years or 30 years. A 15 year loan will save a lot on the total interest paid. In most cases you can save over $100,000 in interest with a 15 year loan.

How do Construction Loans Work: Interest Rate
The rate you get depends on your credit rating, as well as the current prime rate. Improving your credit score before applying for a loan can save you a bundle.

Construction loans vary in their exact specifications. In general there are several ways that the lending institution can work with you, to meet your specific loan needs. Your loan officer will speak to you about the loan, and determine your needs. It is very important that you are honest with your loan officers about your financial situation. If you are honest, your loan officer may be able to help you get a loan in spite of any shortcomings, but if you do not tell your loan officer, and some discrepancy shows up between your application, and the facts you might be turned down for the loan. Banks are usually helpful in explaining their loan process. Continue to research the loan rates and available loans to answer the question; “How do construction loans work?”


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