How do Construction Loans Work?

Construction loans rates will be comparable to fix and flip and other hard money loans. With a traditional hard money loan the property acts as collateral, it is the same with construction. The land or partial completely structure will be the collateral. If the loan amount desired exceeds the value of the property then some or all of the funds will be held back to be completed in draws or tranches. This simply means funds will be released as work is completed and value is added to the property.

Because construction loans are on such a short timetable and they’re dependent on the completion of the project, you need to provide the lender with a construction timeline, detailed plans and a realistic budget.

Once approved, the borrower will be put on a draft or draw schedule that follows the project’s construction stages, and will typically be expected to make only interest payments during the construction stage. The lender pays out the money in stages as work on the new home progresses.

These draws tend to happen when major milestones are completed — for example, when the foundation is laid or the framing of the house begins. Borrowers are obligated to repay interest on the principal amount of the loan until construction is completed and you can payoff the loan.

While the home is being built, the lender has an appraiser or inspector check the house during the various stages of construction. If approved by the appraiser, the lender makes additional payments to the contractor, known as draws. Expect to have between four and six inspections to monitor the progress.

Depending on the type of construction loan, the borrower might be able to convert the construction loan to a traditional mortgage once the home is built. This is known as a construction-to-permanent loan. If the loan is solely for the construction phase, the borrower might be required to get a separate mortgage designed to pay off the construction loan.