What Is a Construction Loan?
A construction loan is a specialized financial product designed to cover the expenses of building commercial or residential real estate. Whether you’re a real estate developer or an individual looking to build a custom home, a construction loan can provide the funds you need. Typically, these loans are short-term and replaced by longer-term mortgage financing upon completion of the project.
Construction loans are considered riskier and thus usually come with higher interest rates compared to conventional mortgage loans.
Key Takeaways
- Flexibility for Various Projects: Construction loans can cover costs involved in building or extensively remodeling a house.
- Short-Term Nature: These loans usually last about a year and are then transitioned into long-term mortgage loans.
- Credit Requirements: Strong credit history is crucial as the loan is not collateralized.
How a Construction Loan Works
Construction loans generally are short-term agreements, typically lasting only one year. Once construction is complete, borrowers can either refinance the loan into a permanent mortgage or apply for a new loan to pay off the initial construction loan. This process is sometimes referred to as obtaining an “end loan.”
For some, there’s the option to take out a construction-to-permanent loan, which automatically converts to a mortgage once the home is finished. During the construction phase, applicants may be required to make interest-only payments. In certain scenarios, the loan balance must be fully paid off once the construction is complete.
If the borrower is an individual building a home, the lender might release funds directly to contractors in accordance with a predetermined drawdown schedule aligned with project milestones.
Construction loans can also be used to finance not only new builds but also rehabilitation and restoration projects. Although enabling the creation of one’s dream home, due to the inherent risks they usually come with higher interest rates and require larger down payments.
Eligibility Requirements for Construction Loans
Due to the inherent risks, construction loans often have stricter credit requirements compared to regular mortgage loans. Since the property itself doesn’t yet exist, it can’t serve as collateral in case of loan default. These loans are commonly provided by local credit unions or regional banks familiar with the local housing market.
Here’s what you generally need:
- Down Payment: Most lenders require at least a 20% down payment, though some may ask for as much as 25%.
- Strong Credit History: Limited or poor credit standing, or excessive existing debt, can make it more difficult to secure a construction loan.
- Detailed Project Plan: Fighting for approval will also involve providing a detailed list of construction details, often known as a
Related Terms: Mortgage Loans, Home Equity Line of Credit (HELOC), Owner-Builder Loans, Real Estate Development.
References
- Virginia Credit Union. “Financing Your Dream Home with a Construction Loan”.
- Consumer Financial Protection Bureau. “What is a Construction Loan?”
- Virginia Credit Union. “Financing Your Dream Home with a Construction Loan”.
