How Do Construction Loans Work?

Many people dream of one day building their own home. Choosing floor plans, trim packages, and paint colors can be fun and exciting!

Finding a way to finance a home build can be daunting and difficult. Most people cannot afford to pay for the cost of home construction up front, and getting a mortgage can be complicated. After all, you’re asking a bank to give you money for something that doesn’t even exist yet. A standard mortgage loan is not an option as it is designed to finance an existing or finished home. You will need to obtain a construction loan to finance the project during the building process.

A construction loan is typically a short-term line of credit used to pay for the cost of building a home. It may be offered for a set term (usually around a year) to allow sufficient time to build your home. At the end of the construction phase, when the house is complete, you will need to refinance the construction loan and obtain permanent financing.

Once you are qualified and approved for a construction loan, the lender begins disbursing the money to the builder as the construction progresses. These disbursements are called “draws”. Draws are designated intervals at which the builder can receive the funds to continue with the project. There may be several draws throughout the duration of the build. For instance, the builder may get the first 10% when the loan closes, and the next 10% after the lot is cleared and the foundation is poured. The next disbursement of money may come after the house is framed, and then the subsequent payout after the house is under roof.

The number of draws and the amount of each is negotiated between the builder, the buyer, and the bank. It is common for the bank to require an inspection at each draw request before releasing the money to the builder. This helps to ensure that everything is on track and that the money is being spent as it should.

With a construction loan, as with all other loans, you must pay interest on the money you borrow. Typically, construction loans require monthly interest-only payments. The construction loan is a line of credit so you will only pay interest based on the amount borrowed throughout the construction phase.

Building a home can lead to a level of satisfaction that you can’t achieve through buying an existing home and enables you the ability to tailor-make a home to fit your specific needs and desires. If you have the financial ability and partner with a lender who possesses the tools and experience needed to help you through the process of a construction loan, you can achieve what so many dream of – building your own home.

If you’re interested in discussing a construction loan, contact a mortgage lender at CNB. We’ll be happy to meet with you to walk you through the process.