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Construction loan basics to keep in mind

Date posted:  5/14/15 08:45:00 AM If not paying cash, homeowners must get a construction loan to build their home.

Purchasing a new home is one of the most rewarding and satisfying life experiences, yet many times it can also be a stressful venture. This can be especially true for those who choose to build their own home, rather than buy an existing house. When building a home, prospective owners must face additional guidelines and processes beyond what is required when simply applying for a mortgage. And because there are many different construction plans and loans available, it can be difficult for new property owners to decide how to move forward with building the home of their dreams.

Below are two primary construction loan factors that should be considered:

"Lenders typically format construction loans as installments."

Cost of the loan
Construction loans may be more expensive than a traditional home loan, and this is simply because lenders may be exposed to additional risks through the construction process. Lenders are able to appraise the value of an existing home based on its condition, location, etc. - many times in the course of a review. By looking at the credit histories and financial standings of those seeking a home loan, banks and other financial institutions are able to gauge how much applicants can reasonably afford and whether the mortgage should require higher or lower interest rates. 

However, lenders do not have this same type of assurance when it comes to a home that is not yet built. It's much more difficult to accurately ascertain what the home will look like and how much it will be worth without seeing blueprints beforehand. Because of this, applicants are often required to submit drawings, contractor agreements, specifications and the overall design of the building. In some cases, owners may have the option to choose from a model building template. Choosing to customize a model home speeds up the construction process by providing lenders with examples of already-built homes just like it, which provides them with a more accurate appraisal opportunity.

Structure of the loan
Lenders typically format construction loans as installments paid at various points during the construction process. Applicants must first submit a down payment, also known as an equity contribution, before the loan amounts are disbursed. The equity contribution and the loan amounts together cover the cost of labor, materials and other construction-related expenses. An appraiser will inspect the progress of the home throughout the build project and report back to the lender to ensure that the timeline and agreed-upon specifications are still valid.

Because building a home can take less than a year, funds are disbursed as short-term "draws" that commonly have interest included. Upon completion of the home, owners pay a final closing cost, which repays the loan, or they roll over the construction loan into a permanent mortgage with a lender. If the lender offers it, a construction-to-permanent loan transitions to a traditional mortgage as soon as the construction phase is complete. This type of loan can potentially save owners money because there is only one closing cost at the end of the loan term, which will be decades down the road. However, some home builders may opt to keep the two loans separate so they are free to shop for the best rates and terms for each type of loan.

With current interest rates at relative lows, now could be a good time to apply for a new construction loan. Take advantage of these construction loan basics, and begin building the home you've always wanted.

and begin building the home you've always wanted.