Construction loans are short-term loans that enable the construction of a project to completion. Upon completion, the permanent loan or "end financing" will be used to pay off the interim construction loan. The term on a construction loan is short duration of 6 months to a year.
Typically construction loans use a draw system of payouts instead of a one-time lump sum payout of a standard mortgage loan. A draw system means the lender will pay out the proceeds of the construction loan at specified intervals (usually monthly) after they have verified the amount of work that has been completed on the project. The lender will usually send out their own inspector or use a third-party appraiser to verify the percentage of the project completed and appropriate payout.
The borrower pays interest only and only on the amount drawn each month. These funds are used to pay for the work performed by the subcontractors and the materials that were used.
There are different types of construction loans based on the specific purpose and the person who takes out the loan. Normally, construction loans are given to general contractors who are building homes for clients (pre-sold homes) or building a home to be sold upon completion (speculative home). On a pre-sold home the lender will loan up to 80 percent of the value or purchase price of the home.
Speculative home loans are typically restricted to no more than 70 to 75 percent of an appraised value based on the plans and specifications provided by the builder. The big advantage for the consumer with a speculative loan is that the general contractor is responsible for all costs associated with the construction loans, including any additional interest that would be charged for construction delays.
Construction loans may also be available to individuals who may already own their own lot and can provide evidence that they either have a general contractor or can prove they have sufficient knowledge and expertise to act as a general contractor. These loans would also be limited to 80 percent loan-to-value. If the lot is already owned by the borrower, its value can act as all or part of the borrower's equity. A construction-permanent loan may also be an option to the borrower. The advantage of this one-time close (instead of the two closings normally required) is one set of closing costs and potentially an easy way to lock in the interest rate for the time taken to complete the project.