A construction loan is a type of short-term loan used to finance the construction of a new home or the renovation of an existing property. It differs from a traditional mortgage loan, which is used to purchase a completed home.
Construction loans are generally provided by banks, credit unions, or other financial institutions and have unique features to accommodate the specific needs of a construction project.
You apply for a construction loan with a lender, just like you would for a regular mortgage. The lender will evaluate your creditworthiness, income, and other financial factors to determine your eligibility.
The lender will also evaluate the construction project itself, including the plans, budget, and timeline. They may require detailed plans and cost estimates from a qualified architect or builder. The lender needs to be confident that the project is viable and within budget.
Construction loans are typically short-term loans with terms ranging from six months to a few years, depending on the lender and the complexity of the project. During the construction phase, you'll only be responsible for paying interest on the amount disbursed, often referred to as "interest-only payments."
As construction progresses, the lender will make periodic disbursements to the builder or contractor. These disbursements are made in installments, often tied to specific milestones or phases of the construction project. The lender may send an inspector to verify the work has been completed before releasing funds.
As mentioned earlier, during the construction phase, you're only required to make interest payments on the disbursed amount. These payments are based on the outstanding balance of the loan. Once the construction is complete, the loan transitions into a traditional mortgage.
After construction is finished, the construction loan is typically replaced with a permanent mortgage, which is a long-term loan used to pay off the construction loan. This loan can be a fixed-rate or adjustable-rate mortgage, depending on your preference and the available options. It can also be refinanced if rates have changed in your favor since the start of your project.
It's important to note that construction loans often come with higher interest rates and may require a larger down payment compared with traditional mortgages. Additionally, you should be prepared for the possibility of cost overruns or delays in the construction process, which can affect your financing needs and the overall project timeline.
Construction loans can be a great way to become the owner of your dream home, but it helps if you think through the best way to manage the loan’s principal. Working closely with a qualified lender and builder with experience with construction loans is essential to ensure a smooth and successful construction project — and to ensure you fully understand what you are taking on before signing anything.
If you are considering a construction loan for a new home or renovating your existing home, it is critical to understand how it fits into your overall financial situation.
Make time to speak with your financial advisor, or if you don’t have an advisor, schedule a complimentary discovery call with one of our financial planners. They can help you better understand a holistic financial plan and how it can benefit you and your plan for your dream home.
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As the Director of Planning & Strategy for Spaugh Dameron Tenny, Jordan applies his academic and practical experience in the creation and maintenance of the firm’s financial plans, as well as coordinating research efforts for products and strategies that may benefit clients. Originally from Canada, Jordan came to Charlotte on a golf scholarship where he attended Queens University of Charlotte. In addition, Jordan has a Master’s degree in Wealth and Trust Management.
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