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Residential Construction Loan

Learn about how a residential home construction loan works

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The residential construction loan

When you contract to build a new house, there are two ways the builder can finance the construction loan.

First, the builder can borrow the money from the bank, build the house and you will close on the house upon completion. Your loan would be the same as a loan for purchasing an existing home. The financial costs of the construction loan are usually built into the price of the house by the builder.

Second, your builder may ask you to get a construction/perm loan. In this case the builder is acting as a contractor and you assume all responsibility for the construction loan. The cost of financing the construction loan is passed on to you and should be considered when comparing the cost of building verses buying an existing house.

This is called a construction/perm loan because when the construction loan is finished the lender will modify the loan to a permanent loan.

Construction Loan Glossary

Important Note Since construction lien laws vary from state to state you should take the time to research how they work in your state. All liens accrue to the property and when you do a construction loan in your name, you are responsible for the liens. It is extremely important that you deal with reputable, financially sound builders so that you do not end up with financial issues at the end of construction.

Builder:

The owner of the property who builds a house for later sale to a home buyer. The construction loan is made directly to the builder based on the builder's credit and experience. When you build a house with a construction/perm loan in your name, then the builder is called a contractor.

Builder's Risk Insurance: A type of homeowners insurance that covers your house during construction.

Construction Fund:

The amount of money the bank holds for financing the construction of the house. The amount of the construction fund must be enough to cover the "hard costs" of construction.

Construction Contract:

Your builder or contractor will draw up a contract that will include all of the details about the house, about the financing, who is responsible for insurance during construction and other details about delivery time etc. This document is the most important document you will sign and if you do not read it carefully it can cost you money and/or distress. If in doubt, have it reviewed by an attorney.

Construction Lien: Liens on real property that are filed by a party furnishing labor, materials, or services for the construction of an improvement, and who are not paid after performing such a service.

Construction Loan Agreementt: The agreement between the builder or contractor and the lender regarding how the construction loan will be handled. It is designed to protects the rights of the lender and the owner.

Contractor:

Anyone who contracts with a property owner to improve real property. Loan funds are usually disbursed to the contractor for work performed. It is the contractor's obligation to pay the sub contractors hired to perform work on the job.

Cost Breakdown:

An itemization of the cost of all components of the house. Usually these numbers are based on bids or estimates from the subcontractors. For example: Plumbing, roof trusses, painting etc. The lender typically uses the cost breakdown to determine the funds needed in the construction fund.

Disbursement at Closing:

The amount of funds disbursed from a construction loan at closing. Typically a lender will disburse between 70% to 80% of the acquisition cost of the land. Closing costs may be paid from the loan fund. The remaining monies from the loan will be placed in the construction fund.

Draws: The method by which the construction fund is disbursed. Typically there are five or six draws of equal size. Draws may be disbursed based on actual bills presented by the builder or by the percent of work completed. When the percent completed method is used there is usually a detailed draw schedule showing each phase. For example: Draw one. "Foundation poured, concrete block set and tie beam poured." Draw two. "Roof on, interior framed, rough plumbing." Draw three. "Window frames installed, roof complete, rough electric, a/c duct work, and wallboard hung." Draw four. "Drywall complete, exterior complete, bath tile complete, and cabinets and trim complete." Draw five. "All painting complete, all concrete (driveways, patio and walks) complete, plumbing fixtures complete, A/C unit installed, and electric complete."

Draw Schedule: Details exactly how the construction loan will be disbursed. see draw.

Hard costs:

The funds associated with the construction costs of materials and labor needed to complete the house. It does not include the overhead, profit and sales costs associated with the house.

Lien: An obligation to pay a sum of money that is attached to fee simple title.

Owner:

An individual or entity that holds a legal interest in real property. For lender purposes it is the owner who is the borrower for the construction/perm loan and is obligated to repay the loan.

Plans

The architects drawings that will be used by the appraiser to estimate the cost of building the house.

Release of Lien A release form signed by the person or entity that placed a lien on a real property. Used when an obligation to pay money is satisfied.

Specifications:

A detailed list materials and fixtures that will be used in the house. This also help the appraiser estimate the cost.

Sub Contractors:

Anyone who enters into a contract with a contractor to perform part of the contract between the contractor and the owner. Sub contractors are the most likely not to get paid and therefore the most likely to file liens.

Financing Construction Loans

As you can see, there are many unfamiliar terms associated with construction lending. And there are as many variations of administering construction loans as there are banks and credit unions.

You should seek out lenders whom will do the most to satisfy your needs. Generally, borrowers want the maximum amount of money disbursed as early as possible during the loan process. At the construction loan closing, some lenders will disburse up to 80% of land value for land acquisition, while others will disburse only 70%. Other variations may include hold backs on the loan disbursements. Some lenders may allow closing costs to be deducted from the construction loan funds.

Lenders also vary on the method of calculating Draws amounts. Some banks base draws on paid bills, others use a method based on the per cent of work done, and still others disburse based on specific work being completed. (ie foundation poured, rough plumbing installed.)

Lenders also vary as to the type of construction loan offered. Some lenders will make construction loans that may be may be modified to fixed rate loans at completion of construction. Others will make only construction loans. The latter is more expensive for the you since closing costs will have to be paid again when the customer closes on the permanent mortgage.

The interest rate during construction is also of concern to the owner. Most lenders peg the interest rate to prime rate which means your interest rate can go up or down during construction as prime rates change. There are lenders who will fix the rate during construction. Shop around for what is best for you.

Typically, during the construction period, loans accrue interest only on the amount of funds disbursed. Customers are billed for interest monthly.

About the Author

Gary Crum is a nationally published author with over twenty five years of management experience in the banking industry. He has a BSBA in Human Resources Management from Florida State University and an MBA from Florida Atlantic University.