A Construction Loan is form of a residential financing taken out by a consumer to finance the construction of their custom home.  They are typically short term in nature and average between 6 to 12 months in duration.

Construction loans can be used to acquire the land to build upon, unless the consumer already owns the property and finance the actual construction cost to have the house built.  The amount of the loan is based on the cost or value of the land depending on whether the lot is owned prior to application, plus the cost to construct the new dwelling.

Banks will typically lend a percentage of that total which is known as the Loan to Value Ratio.  They disburse the funds necessary to acquire or payoff the lot at closing, less the borrowers required investment / down payment and the balance of the funds are placed into an escrow account for future disbursement as the house is built.

The rates on these loans are typically higher than permanent loans due to the increased level of risk to the financial institution as they are lending against a hypothetical house which has yet to be built as well as the short term nature of these loans.  Most construction loans will have a variable rate of interest tied to the prime rate plus a profit margin and the client pays low interest only payments based on the average outstanding balance as the home is being built.

The borrower pays interest payment only on the amounts the bank has actually disbursed from the escrow account and is based on the average outstanding balance.  After the initial disbursement, if necessary at closing, the balance of the funds are placed in escrow with the lender and disbursed to the builder after he/she has completed a certain progress milestone.  This is known as a draw disbursement.

The builder typically reaches a completion milestone and contacts the bank for a draw against the escrow account.  Most banks contract with an independent qualified building inspector to have them inspect and confirm the work required has been completed in workmanship type manner, the County, Township or local regulatory agents have signed off confirming the work has met local building code and they send a report to the lender confirming the completion.

The bank then disburses the required funds allocated toward that stage of completion to the builder form the escrow account which increases the borrower’s loan balance and the monthly interest payments.  This process continues until time of completion.

Once the new home has been completed, it has been agreed to by all parties and the local regulatory agency provides a Use and Occupancy Permit (confirms the property meets all local codes and is livable by their standards), the final draw payment is released to the builder and the borrowers move in to enjoy their beautiful new home.

They must however refinance the loan and obtain permanent financing.  Newer variations of this financing have been made available to facilitate and even eliminate the need to refinance at time of completion.  They are known as Construction / Permanent loans.

Check out our Pathway to your new Custom Home for a step by step pictorial guide to the entire process of building a new custom home.