What Are Construction Loans?

A construction loan is the type of loan that one gets to finance the construction of a new building or buildings. There are two basic kinds of construction loans: home construction and commercial construction. New home construction loans are typically acquired by the homeowner to cover the cost of the builder and building materials. Commercial construction loans are acquired to cover the cost of building commercial or industrial structures.

Typically, the borrower needs to provide specific details about the building that is undergoing construction in order to acquire financing for the venture. The lender needs to ascertain the likelihood that the borrower will be able to repay the loan. If the borrower owns the land that the new home is being constructed on, that fact increases his chances of receiving the loan.

Two basic terms are offered for construction loans: short term or long term. Long-term construction loans offer more flexibility than in the past and provide such terms as 15 or 30-year fixed, interest only loans, and a variety of adjustable rate mortgages.

The short-term loan is in place only as long as it takes to complete the construction and acquire a certificate of occupancy. The lender provides money in intervals to the builder so that the work can continue to progress. The typical time frame for the short-term or construction part of the loan is 6 or 12 months.

Construction loans are often set up so that the lender collects only the interest portion of the loan while the home is under construction– the interest only loan. At the time the construction is completed, the loan either becomes due in full to the lender, continues as an interest only loan before being converted to a traditional loan, or it is converted to a fixed or adjustable rate mortgage loan.

If the loan is converted to a mortgage loan, this is known as a construction-to-permanent loan or financing program. The advantage to setting your construction loan up to convert is that you only need to complete one application and you only attend one closing. The disadvantage is that the interest rates on traditional loans can change during the time it takes to construct the home. Construction-to-permanent loans are also known as one-time close loans since you only attend one closing and save on closing costs.

Some construction-to-permanent loans allow you to lock in an interest rate through the construction and up until its completion. However, it is important to have an understanding of current interest rate trends at the time you apply so that you have a clear understanding of the advisability of locking in your interest rate. Plus, due to the possibility of construction delays, you should include an allowance for this in your agreement.