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Home Construction Financing

Construction Financing Background

The latest trend in home construction financing is construction-to-permanent financing. This is a relatively new product and has opened up more options for people trying to finance construction projects. Historically when financing new construction, the process involved shopping for and closing on two separate loans. The first loan paid for the cost of construction, but was a short-term product. The second loan was the permanent long term mortgage which would pay off the construction loan. Each loan would incur closing costs for the buyer.

Note to buyers: before building, be sure to read Why You Should Hire an Architect, and learn about the Basics of Architecture.


Construction-to-Permanent Financing

The advent of construction-to-permanent products has simplified the construction financing process. Instead of shopping for two loans, a single combination product handles both the construction phase and the permanent financing phase. These loans require only one closing, and therefore closing costs are only paid once. At the onset, the product works like a basic construction loan to facilitate draws for paying for contractors and materials when building a home. However, upon completion of construction, and after all contractors and suppliers have been paid, the loan automatically rolls into a permanent mortgage. The bank determines a home is complete when a certificate of occupancy (or equivalent) is issued. In many cases, the bank will also require lien releases from all contractors prior to converting the product.


Construction Financing Considerations

By definition, construction financing is more risky for lenders than other types of loans due to the lack of collateral to secure the loan. As a result, construction financing is subject to more rigorous underwriting. Typically the products are designed for the short term (6 to 12 months), which can create some challenges if the construction drags on longer. Also, with a construction-to-permanent loan, interest rates are usually variable during the construction phase and may have less flexibility to secure the best long term rates when converted to a permanent mortgage. Lastly, the construction loan market targets more conservative loan-to-value ratios which means buyers are usually required to pay a hefty down payment in the range of 20% to 25%.


Basics of Construction Loan Draws

In construction financing vernacular, draws (or bank drafts) are used to pay for contractors and materials required for construction. The draws align to a predefined schedule based on stages of home completion. Most banks exhaust the down payment initially, prior to accumulating a loan balance. This ensures the buyer has skin in the game and assumes the most risk. Before each disbursement, the bank will normally conduct an onsite inspection to track progress and validate the funds are being used appropriately on the project. This keeps the release of funds in proportion to the progress of construction.

As the loan balance increases with each draw, the outstanding funds incur interest. Most banks allow the interest obligations to be handled by the buyer in one of two ways. One option is for the buyer to make interest-only payments on the loan balance during the construction phase. The other option is to establish an interest reserve upon initiation of the construction loan which will be used to pay interest on the construction loan during the construction process. This means the buyer won’t have to make any payments during the construction phase by essentially rolling the interest incurred into the permanent mortgage.


It is Worth It

Although construction financing is more difficult to obtain than financing the purchase of an existing home, the benefits far outweigh the challenges. Your new home will be custom designed for the way you live, have more safety features, and be more energy efficient. Best of all, it will welcome you every time you come home, walk through its spaces, and bask in its warmth and comfort. This is what building an Expressive Home is all about.