Construction Loan

Updated on March 19, 2024
Article byKumar Rahul
Edited byKumar Rahul
Reviewed byDheeraj Vaidya, CFA, FRM

What Is A Construction Loan?

A construction loan is a short-term finance that pays for all the expenses involved in constructing a project. It aims to pay for expenses such as purchasing land, creating blueprints, obtaining permissions, and payment for supplies.

Construction Loan

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It aims to borrow money to pay for the supplies and labor required in construction work. Loans are often granted for 12-18 months and are meant to spend the construction cost. Upon completion of construction, loans automatically turn into permanent mortgages. However, these loans are not secured and are riskier than other loans.

Key Takeaways

  • A construction loan is short-term finance given to fund the construction of a home, business, or other real estate property. Contractors or real estate developers seek these to finance large construction projects.
  • Loans are frequently given out for 12-18 months to pay for construction costs. Loans convert into permanent mortgages once construction finishes. Higher construction loan rates and complex procedures of approvals are a cause for concern when obtaining such loans.
  • Interest is charged on the withdrawal amount only and has flexible terms. Therefore, it is for both renovation and construction purposes.

How Does A Construction Loan Work?

It enables the borrower to meet short-term expenses incurred during a construction process. In addition, since such loans facilitate the building process, it also allows the borrower to purchase land for the construction process.

In addition, an approval procedure is more complex than a mortgage. Before approving finance, lenders review the financial records of the borrowers. Funds are released in installments as and when different building phases finish after the loan application approval. Such loans function similarly to a credit line. Before each payment, the lender sends a construction inspector to assess the progress.

Interest is chargeable on the borrowings, not the whole loan amount. After construction completes, the borrower can turn such loans into a mortgage, depending on the lender. The borrower may apply for another mortgage or end credit to settle off the loan if no other option is available.

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Types

The following are the three different kinds of building loans:

  1. Loans for only construction: These loans must be fully repaid once the project is finished. Therefore, it is best if the borrower has extra cash or is confident that the proceeds from the sale will be sufficient to pay for another construction.
  2. Loans for building to permanent use: If borrowers have a clear construction strategy and timeframe, they consider using this financing. The bank pays the contractors when construction finishes, converting such loans into mortgages.
  3. Loan for renovation and construction: A construction loan for a home is often sought for the renovation process.

Requirements

Approval of loans will need the following:

  1. Debt-Income Ratio – A borrower’s debt-income ratio evaluates total debt payments to total income. Lenders impose a maximum DTI ratio of 45% when offering such loans.
  2. Repayment CapacityBorrowers must have sufficient income to pay for their existing obligations and the new loan. The lender will request bank statements or other paperwork proving the borrower’s yearly income to prove this.
  3. Improved Credit Score – To lower the risk, banks set a credit score requirement, usually 680. Though, lenders could demand a minimum score of 720.
  4. Approval Of Contractor – lenders seek documents like the builder’s license for quality assurance. In addition, copies of the builder’s insurance certificates, resume, and financial stability documentation must be provided.
  5. Minimum Down Payment For Construction Loans – To qualify for such loans, borrowers typically need to put down a minimum of 20% of the purchase price. In addition, many lenders want an additional 25%–30% of overall construction expenditures.

Examples

Let us understand it through the following examples.

Examples #1

Suppose James is planning to construct a commercial building but is running out of money. So he seeks a loan of $1,000,000 from ABC bank. At first, the bank will ask for contractor approval, insurance certificates, and financial stability documents. After the loan approval, the bank releases the fund in installments depending on the construction phases. Next, banks send an inspector to the construction site, after which it releases the funds to the borrower. Once the construction completes, the borrower can apply to convert such loans into a mortgage construction loan or settle it off.

Example #2

In December 2022, Glacier Capital Partners secured construction financing worth $40 million for constructing a condominium residential tower in Manhattan’s Flatiron district. Bank Hapoalim provided the loan. It was granted for 19 story building at 200 east 20th street.

Pros And Cons

The advantages and disadvantages of it are as follows.

Pros

Some of the advantages of it are as follows.

  1. Interest On Withdrawal Amount Only – The amount tapped for construction receives monthly interest-only payments. Let’s imagine, for illustration purposes, that borrower drew $10,000 at 10% interest. Only monthly withdrawals from the construction fund would be subject to interest payments. The total loan amount would not require an interest payment from the borrower.
  2. Flexible Terms – Compared to traditional loans, such loans’ terms are flexible.
  3. Conversion To Permanent Loan – There is just one closing date, construction is completed, and it qualifies for traditional 30-year debt refinancing.

Cons

The disadvantages of such loans are as follows.

  1. Short-term Loan – At the conclusion, the borrower must repay the loan in full. There needs to be a reward.
  2. Higher Interest Rates – Since the borrower is paying more for the convenience and speed of a 7–10 business day closing, loans have higher interest rates.
  3. Complex Procedure – Due to their relative flexibility, such loans may have more stringent eligibility requirements. These include the actual down payment, credit score, and transaction experience.

Construction Loan vs Home Loan vs HELOC

A construction loan is short-term financing that covers all the costs associated with building a project. On the other hand, a home loan is a one-time payment against the property’s worth. At the same time, a home equity line of credit is a loan secured by the property that allows the borrower a credit line to utilize for major expenses or to consolidate debt from other loans with higher interest rates, like credit cards. Some of the crucial differences between them are:

BasisConstruction loanHome loanHELOC
Funds DistributionCredit lineLump sum
Credit line
Monthly PaymentsVariableFixed
Variable
Interest RatesHigher and fixedLower and variable
Higher and variable
Terms Of Loan12- 18 months60 months,10-year drawn period; advance paid each 15 years.

Frequently Asked Questions (FAQs)

1. Does a construction loan include the land?

Yes, it can be obtained for purchasing the land, as the purpose of it is to facilitate the construction process. Plot and building loans are available to borrowers who wish to buy land and build a home.

2. Is construction loan interest tax deductible?

If the property secured the borrower’s loan moved into, then the interest on the loan can be written off.

3. What is a one-time close construction loan?

A one-close construction to permanent loan is a home mortgage that allows the borrower to simultaneously complete the loan and the permanent financing of a new home.

4. Can you refinance a construction loan?

If the borrower already has a construction-to-permanent loan, they have negotiated two loans and are eligible for a refinance.

This has been a guide to what is a Construction Loan. We explain its types, requirements, examples, pros & cons, and comparison with HELOC and home loans. You may also find some useful articles here –

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