A construction mortgage is a short-term loan used to pay for the construction of a residential property. It can be used to build a new home on bare land or for additions and remodels to an existing property. Builder's loans are risky. Until the home is completed, the lender has limited collateral to secure the loan against. For this reason, the pool of lenders may be quite small.
Construction loans give builders a temporary influx of cash to buy construction materials and labor. Some cover the cost of buying the land; most do not. The typical term is capped at one year, after which the homeowner must seek permanent mortgage financing and repay the construction loan in full.
Builder's Loan Repayments
Construction loans are interest-only loans. The builder is only liable for monthly interest payments during the term of the loan. The principal is due in a single balloon payment when the loan matures. Interest rates vary, but you can typically expect a variable rate that moves up and down with the prime rate. Rates may be higher than those on permanent mortgage loans to reflect the increased risk.
Construction lenders will ask to see the construction schedule, detailed plans of the building works and a realistic budget for the construction. The mortgage industry calls these items the "story" behind the loan. The bank's appraiser will analyze the story and the sale price of similar properties to estimate a value for the built-out home. Lenders typically impose stringent qualification criteria on the builder himself. Most advance loans only to licensed contractors with a track record in building quality homes.
A builder's mortgage is secured against the builder's work in progress. In the early stages of construction, the bank has collateral over little more than bare land and a shell construction. If the builder falls delinquent on the loan repayments, and the bank forecloses, it may have trouble selling a partially-completed home. For this reason, the lender may advance only 75 or 80 percent of the projected construction costs.
Builder's Draw Schedule
Unlike conventional finance, a construction loan is released gradually in stages as the home is built. The lender will establish a draw-schedule that allows the builder to draw cash at certain stages in the construction. The bank may ask its own construction expert to check on the job's progress before releasing a payment. Some construction loans roll over into permanent mortgage finance when the property is complete and receives a certificate of occupancy. The advantage of this arrangement is that the borrower only pays one set of closing costs.