What is a Construction Loan?
A construction loan is a loan granted for the purpose of building homes, offices, or other real estate properties. Construction loans are most commonly granted to builders or property developers to fund a major construction project such as a housing development, office building, or shopping center. However, they may also be granted to an individual to fund the construction of a personal residence.
Funds obtained from a construction loan may be used for purchasing land, paying architects, contractors, and labor, purchasing building materials, paying for environmental inspections and building permits – basically, any legitimate expense associated with a real estate construction project.
- A construction loan is a loan granted for the purpose of building homes, offices, or other real estate properties.
- Construction loans are most commonly granted to builders or property developers to fund a major construction project such as a housing development, office building, or shopping center.
- Such loans come with unique characteristics, such as the length of the loan term and the manner in which loan funds are disbursed to the borrower.
Characteristics of Construction Loans
There are features and characteristics of construction loans that distinguish them from other types of loans, such as home mortgage loans or business equipment financing loans. The following example presents the most common type of construction loan – one granted to a builder or property developer to fund residential property development.
The first and most important concern for a lender extending a construction loan is projecting what the value of the property to be constructed will be once construction is complete. For this reason, the lender will order a special appraisal whose aim is to determine what the likely total sale value of the completed property will be.
An appraiser determines this by considering the location of the property, the recent selling prices of comparable homes in roughly the same geographical area, and, of course, the number of homes being constructed.
Naturally, the credit rating of the builder or developer is considered. It will be a major factor in determining not only if they can qualify for the loan at all but also at what interest rate they may be able to obtain the needed construction loan. Also, lenders nearly always require a substantial cash investment beyond the loan proceeds by the builder or developer. The borrower must also provide the lender with a detailed explanation of the project and the projected construction timeline.
Construction loans are usually a form of short-term financing. They are typically extended for a period of no longer than one year. However, they may be extended for a longer period if a longer period is reasonably required to complete construction. The loan is often structured so that the borrower only needs to make interest payments on the loan during the loan term, paying off the principal balance of the loan at the end of the loan term.
Alternatively, if the borrower cannot pay off the balance in full at the end of the loan term, the construction loan may be converted into a more traditional type of loan, such as a mortgage loan. Property developers can often pay off the loan balance from the proceeds received by selling lots and homes to individuals during the construction process.
A major feature of a construction loan is that the total approved loan amount is not usually given to the borrower right away, in one lump sum. Instead, the construction loan operates more like a line of credit from which the borrower can access funds as needed at various stages of the construction project.
For the borrower to draw additional funds from the total loan amount, the lender often requires periodic inspection reports and other documentation. It helps assure the lender that the construction project is moving on schedule, and the loan proceeds are being used for legitimate building purposes.
Personal Construction Loans
Personal construction loans, which are granted to individuals looking to build their own home, may be one of two types. A construction-only type of loan provides the projected necessary amount of money to construct a home. An individual who takes out such loans is expected to pay off the loan in full at the end of construction, although they may do so by then taking out a separate mortgage loan on the newly built home.
The other type is what’s known as a construction-to-permanent loan. The loan is structured so that, once construction is completed, it is automatically converted into a traditional mortgage loan.
Construction loans often come with higher interest rates than mortgage loans because of the fact that, at the time of the loan approval, there is no existing property that can be used as collateral for the loan. Therefore, there is greater risk for the lender.
CFI offers the Commercial Banking & Credit Analyst (CBCA)™ certification program for those looking to take their careers to the next level. To keep learning and advancing your career, the following resources will be helpful: