A construction loan is quite different from a normal home loan, in no small part because, when the loan is made, there is no house to act as collateral! If you already own the land when you take out the loan, that can represent some equity, but it’s still much riskier for the lender. As such, interest rates are higher, and construction loans are short-term, typically a year. The principal balance will be due at the end of the period, and until then it is an interest-only loan, such that your monthly payment will just go to cover the interest.
Construction loans aren’t standardized like mortgages. Lenders are deeply involved in the planning and construction process, to ensure that the house built will actually be worth the money they’ve lent. Expect inspections, progress reports, and other monitoring. Not only does the house need to be done in time so you can take out an actual home loan to pay off the construction loan, but if for some reason the builders aren’t paid properly, the lender may find themselves facing a lien that supersedes their claim.
You should also expect to put a substantial amount of money in up-front, and the bank will examine your personal finances very closely to ensure that you can actually make the monthly payments. As mentioned before, if a borrower walks away from a construction loan, it can be especially damaging to the lender, so the lender will tend to insist that the borrower has a strong stake in the construction being completed.
Construction lenders are not as easy to find as normal mortgage lenders because of the complexities of the loans. Still, most banks will have some products available. It is important, as with any large loan, to do your homework and shop around. Construction loans are usually one type of “story loan”, where you will need a very solid idea of your plans and goals going in, and how to explain them, in order to get the loan approved. You will also need pre-approval of a home loan to pay off the construction loan at the end of the term.
There will be closing costs associated with your construction loan, as there will usually be when you take out the home loan at the end of the term as well. To avoid this expense, some people take out rollover or “construction-to-permanent” loans, where the loan is automatically converted by the same lender at the end of the term without new closing costs. However, this may leave you with a home loan which is less favorable than if you had taken out one separately. Some calculations of overall cost versus benefit and the timing of those costs relative to your situation will let you know which option is best for you.
There are many reasons you might desire a construction loan. You may want to build your dream home instead of settling for one that’s not quite right. You may have found a perfect location with no house on it. Whatever the reason, these loans can help, but make sure you’re ready for the complexities, requirements and expense involved.