Construction Loan

A construction loan commonly serves as a temporary financial solution to cover the expenses of building projects, like private residences. Typically, it is provided for a defined duration, typically around a year, to accommodate the construction period adequately. Upon completion of the construction phase, a new loan becomes necessary to settle the construction loan, often referred to as the “end loan.”

Consequently, refinancing becomes imperative, requiring borrowers to secure a new loan that represents a more conventional financing arrangement for the finalised building. This might involve transitioning to a fixed-rate, 30-year mortgage, offering stability and predictability in terms of repayment.

Qualifying for a construction loan

Banks and mortgage lenders often approach construction loans with caution due to several factors. One significant concern is the substantial reliance placed on the contractor responsible for the construction work. Lending institutions extend funds for a project under construction, banking on the assumption that the completed property will possess a certain value.

If complications arise, such as subpar construction quality or declining property values, the bank could find itself in a precarious financial position, having invested in a property whose value does not align with the loan amount.

To mitigate such risks, banks typically impose stringent eligibility criteria for construction loans, which commonly include:

1. Involvement of a Qualified Builder: Applicants are usually required to engage a licenced general contractor with a proven track record of delivering high-quality construction. Institutions may be reluctant to finance projects where the applicant intends to act as their own general contractor or is part of an owner-builder arrangement.
2. Detailed Specifications: Lenders demand comprehensive specifications, encompassing floor plans and material details. Builders compile exhaustive lists covering everything from ceiling heights to insulation types.
3. Building Appraisal by an Appraiser: Despite the challenge of appraising a non-existent structure, lenders mandate appraisers to evaluate building specifications and the land’s value. These assessments are compared against similar properties in terms of location, features, and size to determine the appraised value.
4. Substantial Down Payment: A significant down payment, often around 20% to 25%, is typically required for a construction loan. This ensures the applicant’s commitment to the project and safeguards the lender in case the property’s value falls short of expectations.

Meeting these criteria, along with maintaining a favourable credit rating and providing income information, typically enables applicants to qualify for a construction loan, akin to standard mortgage loan requirements.

How do construction loans work

Once an applicant has met the qualifications and received approval for a construction loan, the lender initiates the disbursement of the agreed-upon funds. Instead of providing the entire amount upfront, a schedule of draws is established.

Draws: Draws are scheduled intervals at which the builder can access funds to progress with the project. Multiple draws may occur throughout the build process. For example, the builder might receive the initial 10% when the loan closes, followed by another 10% after the lot is cleared and the foundation is poured. Subsequent disbursements may occur after framing, and then once the structure is under the roof and sealed.

The number and amount of draws are typically negotiated among the builder, buyer, and bank. Typically, the first draw comes from the buyer’s down payment, putting their money most at risk. Additionally, banks often require inspections at each stage before releasing funds to ensure progress and appropriate spending.

Construction Loan Rate: Similar to other loans, interest accrues on the borrowed amount in a construction loan. Construction loans usually feature variable interest rates, set as a spread over the prime rate. Essentially, this means the interest rate equals the prime rate plus a specific increment. For instance, if the prime rate is 3% and the rate is prime-plus-one, the borrower would pay a 4% interest rate (which adjusts as the prime rate changes).

In many cases, construction loans operate as interest-only loans, where only the interest is paid rather than reducing the principal loan balance. This arrangement facilitates more manageable payments.

Interest is charged solely on the disbursed amount. For instance, if £100,000 is borrowed but only £10,000 has been drawn, interest is only charged on the £10,000, not the full £100,000. Monthly payments are required for this loan, akin to conventional loans, starting low when the borrowed amount is small and gradually increasing as more funds are disbursed to the builder.

Disadvantages

Construction loans offer the opportunity to embark on building projects that might otherwise be out of reach. However, they also come with inherent risks:

1. Delayed completion or exceeding budget: The construction may not finish on time or within the budget, leading to additional costs. Extending the construction loan may incur fees until the project is completed and can be refinanced with an end loan.
2. Lower property value compared to construction costs: Factors like builder performance or market fluctuations could result in the finished building being valued lower than the construction expenses. This may necessitate additional funding when refinancing the construction loan into an end loan.
3. Inability to qualify for an end loan: Significant changes in income or credit during the project could lead to rejection of the end loan application. Since construction loans are temporary, this presents a challenge. Failure to refinance and pay off the balance could result in the lender assuming ownership of the property.