Construction Loans | What are They and How They Work?

Building a home from scratch is a dream come true for many people. However, this can be a daunting process, particularly if you're not aware of the financing options available to you. That's where construction loans come in. A construction loan is a type of loan that is designed to help individuals who want to build their own homes or do renovation work.

This article will explain what construction loans are, how they work, and their benefits and drawbacks.

Table of Contents

• What are Construction Loans?
• How do Construction Loans Work?
• Types of Construction Loans
• What are the Construction Loan Rates?
• Benefits of Construction Loans
• Drawbacks of Construction Loans

What are Construction Loans?

Construction loans are loans designed to provide financing for individuals who want to build or renovate their own homes. They differ from traditional mortgages, which are designed to provide financing for individuals who want to buy existing homes. 

In the construction loan process, the loan amount is given to the contractor who undergoes the construction work. The money is lent in phases after each milestone is completed. After the completion of the project, the loan is converted to a permanent mortgage or paid in full.

Construction loans are typically short-term loans, ranging from six months to a year. They are used to cover the costs associated with building a home, such as purchasing materials, paying for labor, and other construction-related expenses.

How do Construction Loans Work?

Construction loans are typically issued in phases. 

• The first phase is the initial loan, which is used to cover the costs associated with purchasing the land and preparing the site for construction. 
• The second phase is the construction phase, during which the borrower can draw on the loan to cover the costs associated with building the home. 
• The third phase is the completion phase, during which the borrower can draw on the loan to cover the final costs associated with finishing the home.

Construction loans are usually interest-only loans, meaning that the borrower only pays interest on the loan during the construction phase. Once the construction is complete, the loan will convert to a traditional mortgage, and the borrower will begin making regular mortgage payments, which will include both principal and interest.

Types of Construction Loans

The major types of construction loans are:

1. Construction-to-permanent loan
2. Construction-only loan

1. Construction-To-Permanent (C2P) Loan | Single-Close Construction Loans

C2P financing is a type of single-close financing where after the completion of the construction project, the loan switches to permanent financing. It involves only one closing hence only one settlement fee. Hence, it is also called a "one-time close" or "all-in-one" loan. 

The construction period of a one-time close loan run anywhere between 6 to 12 months. During this period, only rent is paid. After project completion, the loan converts to a permanent loan as per the borrower choosing. It can be a fixed-rate mortgage for 15 to 30 years or an adjustable-rate loan. This must be chosen before the completion of the construction project.

2. Construction-Only Loan | Two-Close Loans

In simple words, the two-close loan is a loan with two loan applications and two closing dates. The first application is used to pay for the construction project phase. 

After the construction phase, the borrower applies for a second loan to pay off the construction loan. This second loan is your mortgage. The first loan is mentioned as an "interim loan" and the second loan is termed as a " take-out loan". As it involves two closings. it involves two closing fees which is almost equivalent to one of the premium amounts.

What are Construction Loan Rates?

The construction loan rates in the USA vary depending on several factors such as the lender, the loan amount, the borrower's credit score, and the type of construction loan. Generally, construction loan rates are higher than traditional mortgage rates due to the increased risk involved.

As of March 2023, the average interest rate for a construction loan in the USA ranges from 4.5% to 7%. However, some lenders may offer lower or higher rates based on the borrower's creditworthiness, the loan term, and the loan-to-value ratio (LTV). It is important to note that construction loan rates are typically adjustable rates, which means that they can fluctuate over the course of the loan.

Construction-to-permanent loans generally have lower rates than standalone construction loans because they provide more security for the lender. The interest rate for a construction-to-permanent loan may range from 3.5% to 6%, depending on the lender and the borrower's qualifications.

It is important for borrowers to shop around and compare rates from different lenders to find the best construction loan rate for their specific situation. Additionally, borrowers should consider other factors such as fees, closing costs, and the lender's reputation before choosing a construction loan. 

Benefits of construction loans

One of the main benefits of construction loans

• Provide financing for individuals who want to build their own homes. 
• Allows individuals to customize their homes to their specific needs and desires. 
• Offer more flexibility than traditional mortgages, as borrowers can draw on the loan as needed to cover construction-related expenses.
• Easier to obtain than traditional mortgages. This is because construction loans are typically secured by the land and the home being built, rather than the borrower's credit history. 
• Individuals with less-than-perfect credit may be able to obtain a construction loan, even if they would not be able to obtain a traditional mortgage.

Drawbacks of construction loans

• More expensive than traditional mortgages. This is because construction loans are short-term loans, and lenders often charge higher interest rates and fees to compensate for the increased risk.
• More complicated than traditional mortgages. This is because construction loans involve multiple phases, and borrowers must meet certain requirements at each phase in order to continue drawing on the loan. Additionally, borrowers must typically provide detailed construction plans and budgets

References:

• How Construction Loans Help Finance Your Dream House,by Linda Bell  and Hal M. Bundrick, CFP® , published in  NerdWallet (2021)
• Construction Loans: What They Are And How They Work, by Kiah Treece, Rachel Witkowski, published in Forbes (2022
• What is Single-Close Financing and Why You Should Consider It When Building New
• FHA One-Time Close Construction Loans vs. Two-Close Loans,July 5, 2022