Hello and Welcome to another chapter in construction lending. In this video we will give an overview about construction lending in general, a comparison to permanent loans, and a helpful discussion on the differences between the One time and Two time close construction loans.
So first, let’s talk about the general parameters of a construction loan.
A Construction loan is a short term loan that is used to pay for the construction of a project, in our case, a residential house. Because the collateral has not been built yet, the proceeds from the construction loan are disbursed gradually as the home is built. Basically the construction loan acts as a big line of credit. Before the project starts, there is a zero balance. But as the lot is acquired, the foundation is dug and poured, and work commences, money is disbursed from the loan to the subs and suppliers to pay for the work. As more work is done, the balance of the loan climbs. When all the work is done, and all the bills are paid, the final balance will get paid off by your long term loan.
Interest on a Construction loan also works just like a line of credit—you only pay interest on what you use, and when you use it. For example, if you borrow 25,000 the first month for work on the house, your interest is just on that balance, not the entire amount of your construction loan. Also, the interest payment usually isn’t due each month, but gets paid out of your construction loan, just like a bill for the house. This is so it is not cumbersome for those still selling their current residences to make two payments.
The Differences Between Construction Loans and Long Term Mortgages
Let’s talk about a couple of differences between a long term mortgage, and a construction loan. I think it is helpful to understand these differences as you begin the construction loan approval process.
The main difference of the loans centers on the collateral. As we have discussed, the collateral has not been built yet, so there are different risks that a construction loan has that a long term loan doesn’t. For instance, when you buy a house, all the money gets transferred to purchase the house, and clear title is transferred, and the 1st lien position is secured. On a construction loan, a lot more can go wrong. There are opportunities for mechanics liens, disbursement issues, and many more opportunities for fraud. Now there are policies and procedures in place to safeguard these issues, but these types of problems don’t manifest themselves in a long term loan.
Another difference dealing with the collateral is the builder himself. He is a person that doesn’t guarantee the loan, but is really responsible for building the collateral. Having problems with your builder can delay the project, jeopardize your budget, and put the project at risk. It is a good idea to pick your builder wisely.
Something else to note is the interest rate. The interest rate on a construction loan is important, but since it is only a short term loan, it’s not nearly as important as your long term loan. For example, on a $300,000 loan, a 1.00% difference for a six month construction loan from 4.5% to 5.5% would be approximately $975. For the same 300,000 loan, the difference of 0.125% on a 30 year loan from 5.0% to 5.125% would be $8,280. Many get hung up on the interest rate, when the other features of the loan, like fees, down payment, and flexibility will mean more when it’s all said and done.