Understanding Construction Financing

Understanding Construction Financing

The United States economy relies on a healthy housing market. Recently, this market has seen a steady recovery from a real low period four years ago. Although the housing market has recently slowed down from its height, experts feel that it is basically strong. As a result, a large number of people are still anxious to build new housing instead of purchasing existing homes.

Getting financed for a construction project often requires more work than simply getting a mortgage for an existing home. Lenders assume more risk when they make construction loans versus standard mortgages. Borrowers also assume some risk that is not present with other loans. Before making the decision to build a new home, borrowers need to understand the construction loan process.

Types of Construction Loans

Lenders offer several basic types of construction loans: construction-to-permanent and stand-alone construction. When the borrower plans to act as their own contractor or build the house themselves, they may seek an owner-builder construction loan.

Construction-to-Permanent

With construction financing, the bank is loaning money for something that does not exist as yet. Home buyers need money for the initial construction costs, and then they need a mortgage on the home once it is finished. With a construction-to-permanent loan, the financial institution loans money for the construction, and then when the borrower moves in, they automatically convert the loan into a traditional mortgage.

Stand-Alone Construction

A stand-alone construction loan gives the borrower enough money to finish construction, but then the borrower must secure a mortgage to pay off the construction financing. They have to go through two separate processes, sometimes through different lenders. In this case, the mortgage is considered a “take-out” loan, a long-term loan that is used to replace short-term, higher interest financing.

Owner-Builder Loan

These loans are extremely difficult to get since the home buyer acts as their own general contractor. An excellent credit history, experience in construction, and a top-notch business and building plan are essential to securing this type of financing. Applying to a sympathetic lender is also recommended. Getting one of these loans is not impossible, but it will require a great deal of work.

Who Gets the Loans?

Construction loans may be given to the builder, the prospective home owner, or both. While some larger construction firms acquire their own loans to build homes, the buyer would, of course, need to secure their own mortgage. When a construction company undertakes an entire housing development, they may secure funding for the construction that contains a release clause, meaning they can sell a home to an individual buyer while the rest of the homes remain as loan collateral.
Smaller construction companies may not have this option. These loans are riskier for lenders, so they want to see a history of successful building efforts. In those cases, the individual borrower and not the company would take out the stand-alone or construction-to-permanent loan, leaving the builder out of the financing all together.

Loan Advantages and Disadvantages

A stand-alone construction loan works well for homeowners who need a smaller down payment, often because they cannot sell their current home until the new construction is completed.
This type of loan does come with some risk, however. The borrower cannot “lock in” their mortgage interest rate, so if the rates rise during the construction period, they may find their actual house payment considerably higher than they had planned on. If financial misfortune strikes during the construction, the borrower may not qualify for a mortgage when the time comes to apply.
Also, anyone who gets a stand-alone construction loan will have to pay two sets of closing costs and mortgage fees, which can be significant financial burden.
The construction-to-permanent loan has some clear advantages but can be much harder to get. Borrowers usually must make a 20% down payment. While they only pay interest during construction, that rate is variable, which means loan costs can rise significantly during the initial building phase.
However, borrowers are often able to lock in a favorable mortgage interest rate when construction commences, and they can get standard mortgage terms.

Loan Disbursement

Lenders do not release the funds all at once. First, they must examine the construction plans, and then they will release money in stages. During the process, they will have frequent inspections to make certain that proper progress is being made and that the money is being used correctly. When the inspectors are satisfied, the lender will release the next installment or tranche. This process can be a slow one, but it protects the home buyer as well as the bank.
Lenders have to protect themselves when it comes to construction loans since much of the collateral will not exist until a future date. As a result, they charge higher interest rates for the construction costs. For the home buyer, a construction-to-permanent loan offers the most security, but it will require an excellent credit history and a larger down payment. Stand-alone construction loans are riskier for home buyers but are easier to get and require less money for a down payment. They may be the best choice for large construction firms. As always, borrowers need to consult with financial experts before deciding the best loan/mortgage option to pursue.
November 26, 2018 / by / in
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