Construction Loan?
When do we need a construction loan ?
HOW DO CONSTRUCTION LOANS WORK?
In general, a construction loan will cover the cost of the land and the construction. With these types of loans, there’s also more lender involvement. Before you receive a loan, a lender will want to see your plans, projected budget, and schedule. Using this information, the lender can determine your loan amount.
After approval, you don’t receive the money. Instead, your lender pays your contractor in intervals. Your lender will also likely check the progress of your home’s construction before releasing additional funds.
Each release of money is called a draw. These smaller disbursements help to keep the project moving along according to schedule. Most construction loans have a five- to seven-draw schedule, although some projects require more. For instance, the first draw may cover getting the necessary permits and preparing the land. The next may cover framing and subflooring. You, your lender, and the contractor will determine your specific draw schedule.
During the construction phase, most lenders require you to make interest-only payments. You don’t start repaying the principal until after construction is finished. But this depends on your lender and your loan — some construction loans come with interest reserves, where your lender calculates the interest you would pay and builds it into your initial loan amount.
Once your contractor completes the project, you begin repaying your loan. At this point, repayments for a construction loan work much like a conventional mortgage. You make monthly payments based on a set amortization schedule.
BUILDING YOUR CUSTOM HOME
Now, we can start building. Timing is hard to predict when you’re building a home from the ground, up — every step of the process depends on a ton of external factors.
While there’s a lot that has to happen during construction, here’s what you can expect:
Excavation and Sitework: depending on the condition of your lot, site prep and excavation could take anywhere from a couple of days to two weeks.
Laying Your Foundation: This will be one of three types — slab, crawlspace or basement foundation. To find out more about foundations, read the guide here.
Framing: That is, putting up the entire wood structure and roofing. This is when your future home starts looking like a house.
Mechanical Rough-Ins: Our plumbers and electricians will run all the wires and pipes that reside in your walls.
Exterior Finishes: Installing the stone, brick, or siding that’ll make up your exterior walls. This stage of construction can start anytime after framing is complete.
Insulation & Drywall
Painting
Trim Material & Flooring
Mechanical Installations: The plumbers and electricians return to install things like light switches and bathroom fixtures.
Appliance Installation
Carpets
Final Touch-Ups
When you obtain a construction loan, the financing company typically pays the contractor in installments, known as "draws." These draws are disbursed at various stages of the construction process rather than providing a lump sum upfront. Here's how it generally works:
1. Payment Process:
Draw Schedule:
The construction loan is paid out in a series of draws, which are tied to the completion of specific phases of the construction project. Common stages include foundation work, framing, electrical and plumbing, drywall, and finishing.
Request for Draws:
As each stage of construction is completed, the contractor or builder will request a draw from the lender. This request typically requires verification, such as an inspection or certification from a construction manager or inspector.
Inspection:
Before releasing funds, the lender usually sends an inspector to verify that the work has been completed according to the plan and that it meets all quality standards.
2. Number of Draws:
The number of draws varies based on the complexity and duration of the construction project. A typical project might have 4 to 6 draws, but more complex projects could have more. The specific draw schedule should be outlined in the loan agreement.
3. Amount of Each Draw:
The amount of each draw is determined by the percentage of the project completed at each stage. For example, if the foundation is 20% of the total project cost, the first draw might be 20% of the loan amount. Subsequent draws are made as the project progresses, ensuring that the funds correspond with the work completed.
4. Final Payment:
The final draw is usually withheld until the entire project is completed and a final inspection confirms that the work meets all contractual and quality requirements. This ensures that the contractor finishes the project according to plan.
5. Managing the Draws:
The borrower (you) typically needs to manage the draw requests and ensure that funds are being used appropriately. Some lenders may require detailed accounting or cost tracking for each phase.
The construction loan is designed to ensure that funds are released in a controlled manner, aligned with the progress of the construction project. This structure protects both the lender and the borrower by ensuring that the money is used as intended and that the construction is completed according to the agreed plan. This approach helps manage risks and ensures that the construction project stays on track financially and in terms of timelines.
The timeline for a financing company to process a draw request from a contractor typically involves several steps, each with its own timeframe. Here’s a general outline:
**1. Draw Request Submission
· Timeline: 1-2 Days
· Process: The contractor or builder submits a draw request to the lender, along with any required documentation, such as invoices, proof of completed work, and sometimes updated project schedules.
**2. Draw Inspection
· Timeline: 2-5 Days
· Process: Once the draw request is submitted, the lender often requires an inspection to verify that the requested funds correspond to the completed work. An inspector is sent to the construction site to assess the progress.
o Inspection Scheduling: Depending on the availability of the inspector and the location of the site, this could take a couple of days to schedule and complete.
o Inspection Report: The inspector then compiles a report, which is sent back to the lender for review.
**3. Review and Approval
· Timeline: 2-3 Days
· Process: After receiving the inspection report, the lender reviews the documentation to ensure everything aligns with the terms of the loan and the construction progress. If everything is in order, the draw request is approved.
**4. Fund Disbursement
· Timeline: 1-3 Days
· Process: Once approved, the lender disburses the funds to the contractor. This can happen via wire transfer, check, or direct deposit, depending on the arrangements with the contractor.
Total Time from Request to Payment
· Timeline: 6-13 Days
· Process: In total, the time from when a contractor submits a draw request to when they receive payment can typically range from 6 to 13 days, depending on factors such as inspection scheduling, the lender’s internal processes, and any unforeseen delays.
Additional Considerations
· Prompt Communication: To expedite the process, maintaining clear and prompt communication between the contractor, lender, and inspector is crucial.
· Pre-Agreed Timelines: Some lenders may have pre-agreed timelines for inspections and payments, which should be discussed and included in the loan agreement to avoid any delays.
What should you ask the financing company when you are applying for a construction loan?
1. Loan Terms and Interest Rates
- What is the interest rate on the construction loan? Is it fixed or variable?
- How is the interest calculated and when do I start paying it?
- Will the interest rate change once the loan converts to a permanent mortgage?
2. Loan Structure and Conversion
- Is this a construction-to-permanent loan or a stand-alone construction loan?
- How does the loan convert to a permanent mortgage once construction is complete?
- Are there any additional fees or processes involved in the conversion?
3. Draw Process
- How is the draw schedule structured?
- What documentation is required to request a draw?
- How long does it take to receive funds after a draw request is submitted?
- Are there any fees associated with each draw?
- Can the draw schedule be customized to fit the construction timeline?
4. Down Payment and Equity Requirements
- What is the required down payment for the loan?
- Is there a minimum equity requirement for the project?
- Can the value of the land be used as part of the down payment?
5. Loan Costs and Fees
- What are the closing costs associated with the construction loan?
- Are there any origination fees, inspection fees, or administrative fees?
- Are there any penalties for early repayment or changes to the loan structure?
6. Inspection and Approval Process
- How often will inspections be required during the construction process?
- Who conducts the inspections, and how long does the approval process take?
- What happens if there are delays in inspection or approval?
7. Loan Servicing
- Who will service the loan during the construction period?
- Will the servicing change once the loan converts to a permanent mortgage?
- How can I access my loan account information during construction?
8. Project Delays and Changes
- What happens if the project timeline is extended beyond the original estimate?
- Can the loan amount be adjusted if project costs increase?
- How does the loan handle change orders or unexpected expenses?
9. Contingency Funds
- Is a contingency reserve required, and if so, how much?
- How are contingency funds accessed if needed?
- What happens to unused contingency funds at the end of the project?
10. Risks and Protections
- What happens if the project is not completed as planned?
- Are there any protections in place for cost overruns or contractor defaults?
- What is the lender's process for dealing with construction disputes or issues?
11. Post-Construction Considerations
- How will the loan payments be structured once the construction is complete?
- Are there options for refinancing the loan after construction?
- Will there be a final inspection or certification required before the loan converts?
12. Builder and Contractor Requirements
- Does the lender require specific qualifications or licensing for builders?
- Can I use any contractor, or does the lender have a preferred list?
- What happens if I need to change contractors during the project?
These questions will help you understand the specifics of the construction loan and ensure that the financing terms align with your project's needs. It’s important to have a clear picture of how the loan works, the costs involved, and the expectations for managing the construction process to avoid any surprises down the road.
Is there a hidden fee associated with construction loans?
1. Origination Fees
- What It Is: A fee charged by the lender for processing the loan.
- Typical Cost: 0.5% to 1% of the total loan amount. For a $300,000 loan, this could be $1,500 to $3,000.
- When Applied: At loan closing.
- Is It Necessary? Yes. This is a standard fee that covers the lender’s costs in processing the loan.
2. Inspection Fees
- What It Is: Fees for required inspections during different stages of construction.
- Typical Cost: $100 to $500 per inspection. If there are 5 inspections, this could total $500 to $2,500.
- When Applied: Each time a draw is requested, before funds are released.
- Is It Necessary? Yes. Inspections are required to ensure the project is progressing as planned.
3. Draw Fees
- What It Is: A fee charged each time you request a draw from the loan.
- Typical Cost: $100 to $250 per draw. If you have 6 draws, this could total $600 to $1,500.
- When Applied: Each time a draw is requested during construction.
- Is It Necessary? No. Some lenders charge this fee, while others do not. It’s worth negotiating or looking for a lender that doesn’t charge this fee.
4. Contingency Reserve Fees
- What It Is: A reserve set aside for unexpected costs, sometimes with a fee to hold these funds.
- Typical Cost: 5% to 10% of the loan amount. For a $300,000 loan, the reserve might be $15,000 to $30,000, with fees of $500 to $1,000 for managing the reserve.
- When Applied: At loan closing and during construction if the reserve is used.
- Is It Necessary? Yes, if required. The reserve itself is necessary for managing unexpected costs, but the fees can sometimes be negotiated.
5. Prepayment Penalties
- What It Is: A fee for paying off the loan early.
- Typical Cost: 1% to 2% of the remaining loan balance. For a $300,000 loan, this could be $3,000 to $6,000 if the loan is paid off early.
- When Applied: If you pay off the loan before the agreed-upon term.
- Is It Necessary? No. Not all loans have prepayment penalties, so it’s important to negotiate this term.
6. Conversion Fees
- What It Is: A fee for converting a construction loan to a permanent mortgage.
- Typical Cost: 0.25% to 1% of the loan amount. For a $300,000 loan, this could be $750 to $3,000.
- When Applied: At the end of the construction period when the loan converts to a permanent mortgage.
- Is It Necessary? No. Some lenders charge this fee, but others may waive it. It’s worth discussing with your lender.
7. Escrow Holdback Fees
- What It Is: Fees for holding back a portion of the loan in escrow until the project is complete.
- Typical Cost: $250 to $500 for holding the escrow.
- When Applied: At loan closing or when funds are held back.
- Is It Necessary? Yes. If the lender requires a holdback, they may also charge a fee to manage these funds.
8. Title Update Fees
- What It Is: Fees for updating the title as the value of the property increases during construction.
- Typical Cost: $150 to $500 per update.
- When Applied: Each time the title needs to be updated, often at specific milestones.
- Is It Necessary? Yes. Title updates are necessary to ensure clear ownership, but the frequency of updates and associated costs can sometimes be managed.
9. Builder’s Risk Insurance
- What It Is: Insurance that covers damage to the property during construction.
- Typical Cost: 1% to 4% of the construction cost. For a $300,000 project, this could be $3,000 to $12,000 annually.
- When Applied: Purchased at the start of construction and renewed annually.
- Is It Necessary? Yes. Lenders usually require this insurance to protect the property during construction.
10. Loan Modification Fees
- What It Is: Fees for modifying the loan terms, such as extending the loan period.
- Typical Cost: $500 to $1,000.
- When Applied: If the loan terms need to be changed during construction.
- Is It Necessary? No, unless changes are required. This fee is avoidable if the project proceeds as planned, but if modifications are needed, this fee may apply.
Construction loans can come with various hidden fees that can significantly impact your budget. It’s important to ask your lender for a detailed breakdown of all fees and to understand when and why they apply. Some of these fees are necessary, but others may be negotiable or avoidable, depending on the lender’s policies and your specific circumstances. Always review the Loan Estimate and ask questions to avoid surprises.
