As any builder or investor knows, construction loans differ from traditional mortgages in a few ways, but knowing all of the different aspects and terms particular to construction loans is important in gaining a better understanding of this crucial facet of home construction. In this article, we take a look at the basics surrounding construction loans.
In its simplest terms, a construction loan is a short term loan used to finance the construction of a new build. The length of the loan is usually about a year or written so as to be “on demand” for the lender to determine maturity. It is important to note that a construction loan is carried out incrementally, through a series of ‘draws’.
A draw is an incremental release of funds from the lender to the investor or builder. The reason draws are carried out in this way is because they are based on completed aspects of the build. For example, a borrower may request one draw after a foundation has been set and another draw once the framing has gone up. Typically, inspections take place by the lender before each draw, to ensure that everything is being done according to plan. To speed up delivery of draw funds, some lenders will wire money first and inspect second.
This process is critical in minimizing risk for the lender. It also has direct benefits for you, the builder. In order to receive all draws without issues, it is important to stick to timelines and have all logistical aspects and stages of the build carefully planned out. This ensures you'll get your your draw on time, and can continue building with maximum efficiency. There are numerous draws and numerous payouts throughout the construction process.
Interest Rates of Construction Loans
Average interest rates on construction loans can be as high as over 12%. Most construction lenders require monthly interest payments on an ‘interest only’ basis, meaning only the interest of the loan is paid during construction, and the remaining balance is paid off only after the project is complete.
Some lenders will create reserve accounts which set aside loan proceeds to cover initial interest payments. Even fewer lenders that we know of do what Builder Finance Inc. does - allow interest to accrue to the loan – a practice that can save a borrower considerable money in fees and interest on top of the logistical benefits.
It is also worth noting that there is a concept called “Dutch Interest”. Most lenders, including Builder Finance Inc., charge interest only on drawn funds. However, some hard money lenders are known to charge interest on the committed amount, a practice called Dutch Interest. Watch out for this as it will add considerable cost.
Qualifying for a Loan
Whether or not you qualify for a construction loan depends on various factors, and since lenders are paying out money for a project that doesn’t actually exist yet, the qualification requirements for that first loan can be rigorous. For example, a lender will look at income and credit history. Furthermore, the lender will expect to verify your experience and/or the contractor's experience.
Perhaps one of the most helpful things for having a construction loan approved is for investors and builders to prove their reputability and qualifications. In addition to verifiable experience, this can be done through portfolios, references, detailed plans, and investment history. This gives further peace of mind to the lender, assuring them that all parties are well-prepared and seriously invested in their construction project.
A large part is also your interaction with the lender. Do you deliver documents in hard to read handwriting or is information typed? Do you conceal information that is material? Make sure to be forthright and to put in effort to make good impressions – no lender wants to make a loan to a difficult person.
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