Construction Loans

Construction loans are short term loans designed to finance the building of a home or other structure on a parcel of real estate. Construction loans are a significant portion of the real estate financing industry because very few people can afford to pay cash when they build. Almost every home and almost every real estate development of any sort uses construction loans to finance the actual build-out of the project.

Generally speaking, construction loans are shot-term loans intended. They are intended to be paid off when the building is complete. Typically, they are interest only loans – that is, you or the contractor pay only the interest during the building process; the principal is due at the end of the construction when a certificate of occupancy in issued.

Generally, interest rates on a construction loan are variable rather than fixed. The actual rate is based on the Prime rate or some other short term interest rate. The longer the construction takes, the more likely you are to see a variation in the interest rate on your construction loan.

Your interest rate for a construction loan will be based on a number of factors, including the Prime rate (the rate major banks charge each other), your credit rating, the appraised value of the land you're building on and the bank's appraisal of the home you're planning on building. If you happen to own the land free and clear, you will probably be able to negotiate a bigger construction loan and/or a lower interest rate because the land will be seen as equity in the construction loan. But constructions loans can be arranged even if you're still making payments on the property.

Because construction loans are usually short term, the interest rate isn't as important is it is for longer term real estate loans. A half-point (.05%) or so either way just doesn't increase or decrease the total cost of the loan that much in most situations.

Many individuals who are building their own home take advantage of loan programs that include both the construction loan and the permanent financing. This means you make one application which handles both the construction loan and, once the building is complete, your mortgage. Both the construction loan and the mortgage are handled through the same lender.

When you use a program that combines both the construction loan and the mortgage, your final mortgage amount will include the payoff amount for the construction loan. These combination programs may involve a higher rate on the shorter term construction loan and a lower rate on the mortgage, which can work in your favor. Just be sure you're clear on the interest rates on both parts. The interest rate on the mortgage portion will have a long-term impact on your budget.