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What Are Construction Loans, And How Do They Work?

You may be interested in how much it will take to build a new house or to renovate the one that you have. You will need to borrow the money for this project, but not to obtain a mortgage to move into an existing home. Here are all the details you need to get a construction loan for renovation.

What Are Construction Loans?

A home construction loan provides short-term funds at higher interest rates to help build a residential property.

Construction loans are typically for one-year. During this period, the property must have been built and a certificate of occupation should be issued.

How Do Construction Loans Work?

Variable rates for construction loans can move up or down with the prime. Construction loan rates can be more expensive than traditional mortgage rates. Traditional mortgages use your home as collateral. Lenders can take your house if your payments are not made on time. Lenders don’t have the option of seizing your home if you default on your payments. Home construction loans are considered riskier.

Construction loans come with a tight timeframe and are dependent upon the completion of the project. To help the lender understand your plans and budget, provide detailed construction details.

Once approved, the borrower can be placed on a draft, or draw, that will follow the project’s construction phases. They will normally be expected to only pay interest during this stage. Contrary to a personal mortgage which makes lump-sum payments, the lender distributes the money in stages over the course of construction.

These draws typically occur at major milestones, such as when the foundation is laid or framing begins. Borrowers will not be required to repay interest on funds borrowed until construction is complete.

A lender assigns an appraiser or inspector to inspect the house at each stage of construction while the home is being built. Additional payments are made to the contractor by the lender if approved by the appraiser. They are known as draws. For monitoring the progress of the project, you can expect between four- and six inspections.

The type of construction loan might allow the borrower to convert the construction loan into a traditional loan once the home has been built. This is known as a construction-to-permanent loan. If the loan is used for construction only, the borrower might need to obtain a separate mortgage that will pay off the construction loan.

Types Construction Loans

Construction Loan

A construction-only loan allows for the funding necessary to build the home. However, the borrower is responsible for either paying the loan in full at its maturity (typically less than one year) or obtaining permanent financing through a mortgage.

These construction loans disburse funds based on the percentage of the project being completed. Borrowers are only responsible for the entered payments.

If you need a permanent mortgage, then construction-only loans are more expensive. This is because you must do two separate loan transactions and have to pay two sets of fees. Closing fees can be thousands of dollars, so it is better to avoid another set.

Consider that your financial situation can change as a result of the construction process. Losing your job or facing any other hardship could mean that you are not eligible for a mortgage in the future. You may also not be able to move into your new home.

Renovation Loan

You have the option to compare loan options for renovating an existing home. These can be in different forms depending on the amount you spend on the project.

A cash-out refinance option that is available in this low mortgage rate climate is also an option. The homeowner would take out new mortgages at a higher interest than the existing loan amount and receive the extra in one lump sum.

In general, lenders don’t require homeowners to disclose their plans for using the money. The homeowner will manage the budget, the plan, as well as the payments. If financing is available, the lender will assess the builder, review their budget and oversee the draw pro drawing