A construction loan is typically drawn out by homeowners to finance rebuilding, renovating or customizing their homes as per their needs. These loans also finance purchase of land and the entire process of construction.
Before disbursing a construction loan, the lender would like to know details of the construction and even the past history of the old house if it is a renovation. Most lenders have reservations about financing repair work on old structures. After a thorough assessment of the property and an estimate of the costs to be incurred, the lenders loan a percentage amount of the total. This percentage may go up to 97%, depending on the lender. The borrower has to finance the balance amount as prepayment.
Construction loans are different from mortgage loans. The basic difference is that lenders demand information about the past status of the construction. Also the mode of repayment is different. In most cases, till the time of the construction, the borrower has to pay only the installment on the interest. The loan becomes due when the construction process is complete; and at this time the borrower has to option to get the loan converted into a general mortgage.
One more difference is that construction loans are not disbursed at once. The money is given to the borrower in different slabs. The entire amount is broken down and given during the laying of foundation, erection of frameworks, installation of heating and cooling systems, electric wiring and plumbing, laying of flooring and fixtures and finishing work such as painting, paneling and carpeting. Estimates are drawn beforehand how much amount is to be disbursed at each stage.
Construction loans are of two major types, viz. construction-only and construction-to-permanent. Construction-only loans are those which finance only the building process. They do not finance the purchase of land and the finishing process after the construction. Construction-to-permanent loans are loans that continue after the construction is completed, when the loan gets converted into a standard loan as soon as the borrower gets an occupancy certificate. The advantage of construction-to-permanent loans over construction-only loans is that there is requirement of only one application form and closing charges are to be paid only once.
Construction loans are short-term loans. Hence, they have more rates of interest than mortgages. Rates of interest become higher in construction-to-permanent loan financing in return for better mortgage terms and a better rate lock from the lender. A rate lock in a construction loan means the fixing of the rate of interest that exists during the time of drawing out the loan. Due to this, the borrower is unaffected by rising rates in future.
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