What is a Construction Loan?

A construction loan is a short-term used to finance a home or other real estate deal. They can allow a borrower to build a new construction home, often at higher interest rates and larger down payments than traditional mortgages.

Let’s run through a new construction scenario:

First, you would want to find a lot to build on. When you find the lot, you then want to make a floor plan and determine what the house would sell for after completion.

Then, consider how much money in construction costs it will take to build the home. Builders generally don’t buy the lot and start building right away.

They find and write an offer on the lot, then set the closing date on the lot far enough out so that you and your realtor have enough time to put the plans and building agreement together.

Many builders find that they can save money on closing costs by having a construction loan that covers the purchase of the lot and construction costs.

Direct private lenders or hard money lenders can help you do this. A great hard money lender can help you close in 7-10 business days, which can make a huge difference in Texas markets.

Lenders down payments vary but can generally be around 20-30% of the cost. Putting money down can enable the lender to charge lower interest rates or offer more favorable loan terms.

Down payments vary based on the lender, lot purchase amount, and construction costs needed.

The lender will issue preliminary terms to a prospective borrower to give them an idea of what financing would look like. The objective is to close your construction loan before the builder starts construction.

The money needed for construction will go into an escrow account that is controlled by the title company. Once the builder starts construction, a builder will “draw” from the escrow account. Builders can draw as many times as needed, but four times is a fair estimate. A draw is a way for funds to be taken from the construction budget to pay for material suppliers and contractors.

While the home is under construction, you won’t be making a full mortgage payment. A construction loan is an interest-only loan that are paid monthly.

For example, the builder starts construction. They dig the hole in the ground and pour the foundation for the home. Now, they’ll take the first draw.

Let’s say they draw $40,000 from the construction escrow account to pay the cost to dig the hole and paying the foundation company for the concrete.

Those contractors would go to the title company to sign a lien waiver. A lien is a claim that allows the holder to gain access to the property if debts are not paid.

A lien waiver is a document that is signed in exchange for payment, as it waives the signer’s right to file a lien for the amount on the waiver.

The contractor is waiving the right to a lien because the work has been done and they have been paid. The title company will have an inspector come out to inspect the job and make sure that the work has been done.

You would pay monthly interest-only payments on the amount you drew. If your monthly interest rate is 12%, you would be paying 12% monthly interest-only of that $40,000 that was drawn from the construction escrow account.

Let’s say that the next draw is when the home is being framed. The lumber company needs to be paid, as they are supplying the lumber. The framers will also need to be paid for framing the home.

We could assume that the second draw for lumber and framing would be $45,000. In total, you have drawn $85,000 so far. That’s including all construction costs to date.

The second monthly interest-only payment would be 12% of the $85,000 drawn so far in construction costs.

The third draw could be once the home is insulated, drywalled, and has the finishes.

The fourth draw could be when the home is fully complete.

For each draw taken out, the title company will have an inspector come to inspect the property and have lien waivers signed by contractors.

Note, it’s not an inspector’s job to check quality. It’s the builder/investor’s responsibility to ensure that the project is being done the right way.

Once the home is done, you can now transition from your construction loan into a 20 or 30-year fixed mortgage.

One idea is to wait until the home is done, to lock into an interest rate. This will help you get the lowest possible interest rate.