A construction loan can be simply defined as a credit to build a house or develop a property. It is quite a complex transaction, owing to the fact that the initial lending from the lender to the borrower is different than from usual loans, and there are several intricacies involved in the process of lending and repayment. All lenders tend to follow different policies, terms and conditions, while financing for construction projects.
These loans can be utilized for personal or commercial property. The commercial loans are, in fact, more costly, as compared to normal construction loans. However, the basic mechanism and principles remain the same.
Features of a Construction Loan
This loan is provided to fund the prime cost and overheads of a project. Here are the basic features:
- The loan is usually provided in installments, that is in ‘draws’. A single draw is a small payment of the portion of the loan by the lender to the borrower. This primarily works on the lines of a common Home Equity Line of Credit (HELOC).
- A majority of the loans are secured and a portion of the home equity is pledged as a collateral.
- The interest rate or APR is not levied at a flat rate and is usually made on the basis of a draw.
- Repayment is undertaken through an ‘interest reserve’. The reserve is a locked account of periodic payments where the borrower keeps on pooling the money and the sum gets transferred to the lender on a stipulated date. The reserve is often filled up with wage garnishment, and when there is a break in repayment, a restriction is imposed on the draw. The initial reserve amount is usually small and is only contributed to see through the transaction. As a result of this concept of draw and interest reserve, in several cases, the actual interest rate (in %) is a bit lower than the usual.
- The lenders, in addition, never approve a loan whose principal is equivalent to the total cost of construction. Commonly, about 80% to 90% of the total construction cost is approved.
- The approval process which consists of the underwriting of the loan is also a bit different. During underwriting, the lender tries to calculate the probable loss that he might incur. He would look at first, the income of the borrower plus the income from property and secondly, worth of the property and its equity upon completion.
The first and also the universally applicable step is to research thoroughly on the available options. Making yourself aware of the market, common conditions, mechanism, and procedures is an absolute necessity. Here is a quick elaboration on the steps that you can initiate to get a good deal.
- A pre-qualification is of a high priority. To get a pre-qualification, you will need a steady source of income, a plot of land that has a reasonable projection and will yield a good market price in the coming years, costing of the entire project and lastly, a good equity.
- The second thing that you will need to take care of is fixing the principal amount of the loan, which, as mentioned above, is not always given in full. Then you would need to consider the rate of interest which can be either fixed or floating. Next, you will also need to make provisions for the interest reserve, as once you actually start with the construction, your cash flow will be affected.
- The third step is extremely crucial and it involves working with your lender to get the best possible project plan, a high projected equity and a good market price on the finished project. This makes underwriting the loan quite easy and is also beneficial for both the parties, as lenders want back their money and the land owners want good equity.
- Then comes the actual appointment of contractors. The pre-qualification procedure tends to act like an upper limit budget in the construction cost. Also remember that you have to bear a certain cost on your own.
- This completes the planning and finalization, after which the loan is granted and the draws begin. The draws often directly correspond to the first costs. The second draw corresponds to the related cost incurred at that point of time.
- The last thing that you would need to take care of is to get an insurance, such as property insurance and a general liability insurance.
This procedure is also applicable to commercial construction loans. The only difference is that, during the underwriting stage, the realization value of the property is more relied on for approval.