Construction Loans

A Construction Loan Primer

Construction loans are used to pay for larger renovations, or building on empty land. These are short-term loans that have to be repaid when the construction is finished.

Some lenders specialize in construction loans but do not provide long-term replacement loans. So a second lender is used for the replacement loan. Some lenders provide "construction-to-permanent" loans whereby the construction loan converts to a long-term permanent loan.

Here are some factors relating to a construction loan.

1. Plans and building permits are required. Then a construction contract has to be finalized, which will show the construction price. This process may take many months. A loan can be applied for at the later part of this process, but no funding is available until these steps are completed.

2. Lenders are willing to use the appraised future value for the property in a construction loan. The maximum loan amount allowed is usually between 65% and 70% of the future appraised value.

3. In calculating the loan amount, other amounts must be added to the construction price:

> The loan must include an amount to pay off any lien on title because the construction loan lender will want to be the first lien on title.

> "Reserves" are also added to the loan amount:

(a) A mandatory reserve is the contingency reserve. This reserve allows a cushion of extra money to pay for any additional costs that arise during construction. It is usually 5% of the construction price.

(b) Some lenders will defer pyments, including interest payments, during the construction period. Interest accrues and must be paid once construction is done. To ensure that the borrower has enough money to pay accrued interest, an interest reserve is used. It is usually 5% of the construction price as well.

4. A loan application would include similar information and documents in a regular refinance application. Additional information includes the credit worthiness of the contractor. How much detail is required regarding the contractor depends on the lender.

5. Fixed and adjustable rates are available for construction-to-permanent loans.

6. The term of the construction loan is usually between 9 and 18 months. Some lenders will charge a fee if the term is longer than 9 months.

7. Construction-to-permanent loans are amortized over 30 years. If no payments are made during a one-year construction period, then monthly payments during the permanent loan stage are higher because the loan is calculated as if there are only 29 years left to repay the loan.

For more information, including information on financing costs, no ratio or stated income loans, and worksheets to calculate construction costs, please contact me. There are also other options for real estate investors who may not qualify for a standard construction loan.