Construction loans are short-term value-added loans that are used to finance the construction of a home or another type of real estate project.
How Construction Loans Work
Instead of traditional mortgages, which are based on the existing fair market value of a property, construction loans are higher-interest loans that are based on what the value of the project will be when it is completed. Lenders assume the risk of providing funds for a project that is not even built.
Traditional mortgages provide loans that are paid out at closing to cover the cost of the project. Construction loans are paid out in installments as the various stages of the project are completed, and the total cost is assessed to the borrower at the project’s completion. These loans can cover the cost of land, building materials, construction labor, and permitting.
Types of Construction Loans
These types of construction loans are available:
Construction-to-permanent loans provide funding to pay the costs of building a home, for example, then once the house is completed and the borrower moves in, the loan can become converted into a permanent mortgage with a 15 to 30year loan term.
Construction-only loans provide the funding to complete the project and the borrower is obligated to pay the loan, typically in one year, or to seek extended funding.
Renovation loans can be used to upgrade an existing property. They can include personal loans, credit card financing, or cash-out mortgage refinancing.
Advantages and Disadvantages of Construction Loans
These loans have the advantages of interest-only during the construction process, flexible terms, and because the lender has a lot of scrutiny on the project, the project is more likely to stay on schedule and on budget.
Disadvantages include construction loans are harder to qualify for and they require higher interest rates.
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