How Construction/Renovation Loans Work

Q. Can you explain how construction loans work? Why is it so difficult to find construction loan information on the Web?

A. Construction loans are story loans. That means that the lender has to know the story behind the planned construction before they’re willing to loan you money. Because it’s a story loan, it’s not going to be standardized like mortgage loans underwritten to Freddie Mac or Fannie Mae guidelines. That said, there are some common features to a construction loan. Construction loans typically require interest-only payments during construction and become due upon completion unless it is a construction/renovation to permanent loan. Completion for homeowners means that the house has its certificate of occupancy.

Construction loans are usually variable-rate loans priced at a spread to the prime rate or some other short-term interest rate except for owner occupied construct to perm. You, the contractor and the lender establish a draw schedule based on stages of construction, and interest is charged on the amount of money disbursed to date.

Another variable in construction loans is how much of the project cost the lender is willing to lend. If you already own the land, then that can be considered as equity on the construction loan however some lenders will finance the land/home as well as the construction/renovation costs

Many homeowners look for construction-to-permanent financing programs where the construction loan is converted to a mortgage loan after the certificate of occupancy is issued. The advantage is that you only have to have one application and one closing. The disadvantage is that you will typically have a higher rate on the permanent mortgage because of the additional time required to build a home depending on the lender you choose!

Depending on your view on interest rate trends, you may be able to purchase a rate-lock agreement that allows the loan rate to be fixed prior to the closing of the construction/renovation to permanent loan and eliminates the risk associated with rising rates during the 1-2 years of construction.

A construction loan, unlike a mortgage, isn’t meant to be around for a long time. so many lenders charge a higher rate during construction/renovation so make sure you ask all the right questions when talking to lenders to be sure the lender offers all the advantages that we offer.