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Understanding Residential Construction Loans

By Elizabeth R. Elstien

A construction loan can be a good way to pay for a major addition to an existing home or the building of a new home while also enlisting the aid of the banker who approved the loan. Many loans can be converted into a full mortgage once the construction is completed. Learn how these loans work and decide if this is the right loan type for you.

These loans do come with a hefty price in upfront contingency funds and accrued interest, along with other costs. Learn about construction loans and see if this is the right loan type for your new home building or existing home addition project.

Get Plans Together

Before you can even apply for a construction loan, building plans must be professionally prepared. The construction company selected for the project should be wisely chosen, as this loan has a set time for building completion making a loan extension very costly. A construction contract with a construction company and a cost estimate must be in place prior to loan application.

Apply To Local Banks

Local banks or credit unions are the ones to turn to for a construction loan. These banks know the local market and construction needs. A construction loan is very individualized and cannot be as thoroughly researched or applied for online as other, more traditional loans can. Expect to do lots of paperwork and show that you have a well-thought-out project. Be prepared to prove that you have 20% to 30% of the estimated construction costs upfront partially as a contingency cost due to building overruns, as well as being able to actually afford the project plus any existing mortgage. Land payment can be figured into the construction loan if you can afford to up the down payment amount. Loan approval is usually very quick.

Know Financing Types

Lenders may offer to roll the often short-term construction loan into a permanent mortgage, which is called construction-to-permanent financing. An existing home mortgage and construction loans on the same property may also be combined into one mortgage loan. This saves on closing costs and paperwork. However, construction loans are financed at a slightly higher rate than conventional mortgages, so borrowers may want to shop around for a lower-rate mortgage to convert their construction loan to once building is completed.

Payout Of Funds

Construction loan funds are payed by the bank as needed, so a borrower is only paying interest on the amount owed. But the bank helps borrowers of construction loans not get ripped off by contractors and can help save the borrower money. Bank representatives inspect the building project before each payout to make sure the work is completed. Banks look at fluctuating costs of materials to make sure the current and best price is obtained. Of course, the bank is not selfless. This is done to protect the bank's investment in your home, but it does ease the borrower's strain of dealing with the construction process.

Decide Interest Rate

Construction loans come with a fixed term, usually one year. Interest rates vary and depend on the borrower's needs. Interest-only, adjustable and fixed-rate are options to keep in mind. A loan may be interest-only for a few years and then go to a fixed rate. Many construction loans can be turned into 30-year fixed-rate mortgages.

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