How Do Construction Loans Work

Contractors and construction companies rely on certain types of loans to finance their building projects. Construction loans are used to build homes, vacation homes, commercial buildings and offices. These loans are different from typical mortgage loans for a few reasons. For example, with a traditional mortgage loan, 100 percent of the money that is being borrowed to purchase a home is provided up front. With a construction, the money isn’t provided all at once. Instead, a construction loan is only given out to the contractor or the construction company in incremental amounts. In other words, the borrower will receive only a portion of a construction loan in stages.

Construction loans work by approving the contractor or a construction company for a loan, and then giving out only a portion of the loan until a certain stage of the construction project is finished. Construction projects go in stages, and a building inspector is used to approve the borrower for the next portion of the loan. If a borrower is qualified for a $400,000 construction loan, they may only receive $50,000 at a time. Most construction loans hand out portions of a loan in 20 to 25 percent incremental portions.

Once the building inspector passes the construction project for the next stage, the lender of the construction loan will then give out the next portion of the loan. Unlike traditional mortgage loans, there is no collateral to use for a construction loan. A home that is being built under a construction loan isn’t a finished product, which means the home that is being built cannot be used for collateral on a loan. There are a few advantages to a construction loan that make this type of loan appealing to contractors and construction companies that are in the business of building new homes.

Construction loans usually do not charge principal payments during construction. In fact, most construction loans are known to only charge interest payments to the borrower. This gives the borrower the financial means of finishing a construction project like building a new home. If the borrower were required to pay on the principal during the construction process, they may find themselves dealing with financial hardship when attempting to finish the construction project. Once the home is finished being built, and all the loan has been used for the project, they lender will then require the borrower to pay on the principal.

These types of loans also impose a strict time frame on the borrower, which states how long a builder has to finish the project. Not only must a borrower of a construction loan pass the inspections performed by a building inspector, the borrower also has a time period which they must abide by. For example, if the construction loan contract states that the project must be finished within 12 months, the percentage of payments and the stages will be broken down accordingly. The borrower may have to finish certain stages of the project in 3 or 4 month incremental periods.

Some construction loans require the entire amount of the loan to be repaid once the construction is finished. At this point, the builder may have the opportunity to refinance the construction loan with a traditional mortgage loan, unless there is a buyer immediately after the project is finished. Many contractors and construction companies will obtain a mortgage to pay off the construction loan, using the home as collateral. This is a typically process that is performed until the house is sold on the market. If the borrower has not found a buyer for the house before the project is finished, the borrower may obtain a mortgage on the project at a certain stage of the project.