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03 bank 3. How Do Home Construction Loans Work?

Much like buying a home, building a home requires you to either pay for it outright or get a loan. Here is how construction financing works today:

Financing construction involves obtaining a construction loan from a lending institution. Construction loans are usually considered short term financing. Once the construction project is completed, the loan is typically converted into a permanent mortgage loan.

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Qualifying for a construction loan

Construction loans may be harder to qualify for than a traditional loan. This is because the bank has no collateral in the transaction—the proceeds of the loan aren’t used to buy a finished product. As a result, construction loans are typically interest-only. They usually have a term of one year or less and a higher interest rate to reflect the higher risk of loaning money without a finished product.


When qualifying for a construction loan, the lender looks at your assets and construction plans. Like a home loan, the bank will use an appraiser to value the planned home. However, this is a little trickier since the appraiser has to base the value on a best guess as to the final version of the home and where the market will be several months in the future.

Your assets are also considered to reduce the risk for the lender. If you default on your construction loan, the lender can go after your assets to repay the debt. Many people who apply for a construction loan fully own the land that they intend to build on.

How a construction loan is paid

A home loan is paid out in one lump sum at closing. Construction loans, on the other hand, are paid out in increments, called draws, which are tied to milestones in the construction process. Banks will send out an inspector to verify that the work pertaining to the draw was performed. These draws are included in the budget created during the loan application.

Once your home is complete and you have been issued a certificate of occupancy, the bank will release the remaining funds from the loan to pay the final invoices. Most banks will then require you to take out a standard home loan to repay the construction loan. Some construction loans are set up to automatically roll over into a standard mortgage with the same bank, while others allow you to choose your own mortgage provider.

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Comments (1)

Lora "Leah" Stern 914-772-4528
Coldwell Banker, 170 N Main Street, New City NY 10956 - New City, NY
Real Estate Salesperson

Thanks A.J. for sharing this info.  Though I knew that construction loans were harder to qualify for, I was unaware of the terms and payment procedures.

Jul 07, 2013 11:34 PM