Construction Loans Pros and Cons

Buying a home is a major life decision so, prospective buyers must do a lot of careful thinking and evaluation before making a choice.

Building your own home requires so much more because there are more financial risks and uncontrollable variables that make the stakes higher.

  Think about the many tasks you need to do:  negotiating for the property, securing the permits, perfecting the design with the architects, looking for the right contractor, and projecting your expenses and mortgage payments.  These are all downright formidable.

The good news is, there is such a thing as a construction loan.  It is basically a sum of money that lenders provide specifically to people who are planning to build their homes.  It finances the building costs and helps the prospective homeowner to manage this critical financial undertaking.

Whether your project involves building your house from the ground up or renovating an existing structure, construction loans have certain features that set them apart from your traditional mortgage.  Now, before you say this is what you need, read on and learn the basic features of construction loans and get an idea of how they work in real life.

What’s a Construction Loan?

Perhaps its simplest definition would be a generally short-term that makes funds available to cover the cost of constructing or rehabilitating a home.

By and large, construction loan lenders charge higher interest rates than long-term mortgage loans that people take out to purchase homes.  When you borrow money through a construction loan, the lender will release the funds through a series of advances in synch with the progress of the construction.  A borrower will begin to pay back the loan sometimes within six months to 2 years after he gets the loan.

Borrowers make ‘draws’ against the loan every time he needs the funds.  Every draw is merely a reimbursement to the builder for the costs he incurred for a phase of building.  This means that the borrower should have enough cash on hand, so he can cover and reduce these costs in the meantime.

Before allowing any drawing, the bank will conduct an inspection to check the estimated cost (including hidden cost) of the present phase of construction, as well how the builder and his contractors are moving in relation to their agreed timeline.

Types of a Construction Loan

There are three general types of construction loans that are available to builders:

Construction-to-Permanent Loans

These loans are most appropriate for builders who already have a definite construction plan and timeline in place.  For this type of loan, the bank will pay the builder as the work is progressing.

Afterward, the bank will convert that cost to a mortgage at closing.  The advantage of this type of loan is that the borrower can lock the interest rate at closing, which guarantees that he pays a steady amount for the mortgage.

Construction Only Loans

Construction only loan is a type of loan that the borrower must pay off in full once he completes building his house. 

This is ideal for borrowers with a large amount of cash to work with or if he is confident that the house will command a very exceptional price in the market that can cover another project.

In this type of loan, if the borrower needs a mortgagee to cover the cost, he will have to search for a new lender and apply for a loan a second time.

Renovation Construction Loans

With this type of loan, borrowers may wrap up the entire cost of the construction and renovation of the property into the final mortgage.  The size of the loan will depend on the projected value of the house after repairs and renovations are over.

The borrowers who avail of this loan are those who are searching for a house in need of considerable repairs.  Real estate people call these houses as “fixer-uppers.

Benefits of a Construction Loan

If you’re wondering why you should get a construction loan instead of a home equity line of credit (HELOC) or some other privatized loan, here are some of its benefits:

Flexible Terms

Although banks will require you to furnish them the specific plans for your project, constructions loans are much more flexible with their terms and guidelines compared to traditional loans.

To some extent, this allows you to work you loan terms according to your needs for the project.

Pay Only The Interest During Construction

Since you don’t have to pay out the loan in full until the new construction is complete, the bank will not ask you to start for the principal until then also.

While you’re constructing your home, you only get to pay interest on your loan – it gives you a lower monthly obligation and more time to save up.

Transition to a Permanent Loan

Construction loans have evolved over the years such that more and more borrowers are reaping their many benefits.  One of them is the advantage they can get if they avail of construction to permanent loan.

As previously mentioned, this type of loan will provide the money that a builder needs to construct his house and it gives him the time he needs to pay it back.  Once he finishes the construction, the loan transitions to a mortgage-like loan.

This is particularly helpful for builders who may not have the ability to raise sufficient funds for loan repayment within the short time-frame of the loan.

  Another benefit to the borrower is that he can already negotiate and lock in the interest rate of his loan.

Additional Scrutiny

If you take this type of loan, the lender will demand a deeper and closer look at how you plan to proceed with your project.  This is good for you because an independent party will scrutinize your plans to see if everything is in order.  This will entail you to submit to the bank a clear timeline or schedule of the construction and the details of your construction plan.

To make this available, your contractors must provide you with specific and straightforward information about the dates, methods, materials, workers, etc. they would employ during the actual construction. 

It can help you get the job done according to schedule and within your budget, especially if you are the one personally dispensing the budget.

The Freedom To Choose

Perhaps this is one of the more exciting parts of building your own home – you get the chance to build your family’s dream.  Most homes on the market are pre-built and buyers just look for something that’s “close enough” to what they really want.

If you qualify for a construction loan, you have the liberty to choose your architect and contractor and work with them to customize your home to meet your every want and need.

Disadvantages of a Construction Loan

No financial product is ever perfect so, construction loans also have their own disadvantages.  Here are some of them:

Minimum Requirements

A construction loan may sound simple enough but to qualify for one is not easy and simple.  Since construction loans are very flexible, lenders impose higher qualifying standards in terms of credit scores and down payment.

Generally, a borrower must have a score of at least 680 and be able to put down at least 20% as a down payment.  On top of these, your bank will ask you to submit assorted documents related to your property as well as other important supporting documents before they agree to lend you money.

Higher Monthly Payments 

Your loan term will start when you initially get your loan whether your term is 20, 25 or 30 years.  For the first few months or years, as the construction is going on, you will just have to make interest payments.

However, when it’s time to start paying off the loan, the lender will include the many months when you just paid interest into the computation of your monthly loan payment.  You don’t have to be a math genius to see that this will boost your monthly payments higher.

Partially Loan Payments

Unless your lender agrees to carry the loan at once, chances are, you’ll get your loan in spurts according to the progress you’re making in your construction. Take note that while your house is undergoing construction, you already have to pay interest on your loan.

Remember that interest rates for construction loans are usually higher than rates for a traditional mortgage so be sure to include that when you prepare your budget.

High Interest

Construction loans normally have variable interest rates and lenders add a certain percentage over the prime rate, or the rate they give to their best customers.

For example, if the prime rate is 4.5% and the lender decides that your construction loan rate should be prime plus 2%, you will get an interest rate of 6.5%.

Cost May Be Higher Than Expected

When you buy a pre-built house, the price you and the seller have agreed upon is what you must pay – then, that’s it.  When you’re building a home from scratch, it takes months and while you’re constructing, you may suddenly change your mind on some things.

Any change or modification can increase your cost. Even a seemingly simple thing like a different design for the floor tiles could mean a few hundred dollars more.

Risky Loan

Construction-only loans are the riskiest of the three types.  Remember that at the end of the loan term, the lender will expect full payment of the loan.

If you really want to go through this route, you must be sure that you will have funds to pay off the loan on your own – in case you will not be able to have access to more financing.

Should You Get a Construction Loan?

Construction projects are costly whether it’s a renovation, expansion or a new home – you will need some funds to make it work.  A construction loan is a perfect solution to get the money you will need to pay for the building materials, labor, and other related expenses.

It is best to talk to a business banker to find out what kind of loan you can qualify for because you may have other options besides a construction loan.  In any case, make sure you understand all the pros and cons before you decide on a loan and place your signature on the contract.