How Construction Loans Work - dummies

By Eric Tyson, Robert S. Griswold

Watch your step, please. Be careful. We’re about to enter a hardhat zone. This balloon loan is covered with a fine coat of dust — construction dust.

Like other balloon loans, construction financing is extremely diverse. No one standard loan instrument exists that all lenders use to finance construction projects. On the contrary, the terms and conditions of new construction loans vary widely from lender to lender and project to project.

That variability isn’t at all surprising when you consider the full spectrum of project types and sites. Do you need a small loan to do a little cosmetic painting and landscaping around your house; or are you about to embark upon a major rehab of an inner-city, multifamily dwelling; or do you plan to construct a country retreat from the ground up? Will your project be completed in two months or two years? Are you doing the work yourself, or will you use an architect and licensed contractors?

Financing for small, do-it-yourself type projects is usually handled with home equity loans. Funding of larger projects, on the other hand, is generally paid out in installments as each previously agreed-upon stage of construction is satisfactorily completed. You pay interest on construction funds only as they’re disbursed. After your project is completed, the construction financing is customarily converted into a permanent, long-term mortgage.

Construction mortgage loans are specialized. Many lenders aren’t interested in financing rehabs of major fixer-uppers or making new construction loans. Real estate agents who handle this kind of property generally know which local financial institutions offer construction loans for your specific type of project. Architects and contractors are also good bird dogs for local banks or other lenders who provide construction loans.

Construction loans are typically short term and borrowers are often required to show a schedule and plans before the lender will grant any funds.

Construction mortgage loans aren’t as easy to get as they once were. More common now are construction-to-permanent loans. Typically, the loan and mortgage get combined into a single 30-year mortgage so that the borrowers only have to pay closing costs one time.