What's A Construction Loan and How Does it Work?

Image via WikipediaConstruction loans can sometimes seem confusing to the first time, do it yourself home builder. But in reality they are a simple tool for borrowing the money to build a home. A construction loan is a simple loan used to finance the construction of a home. When the home is completed the loan is due. So a mortgage loan must already be set up and take affect at that time. Traditionally, you apply for both loans at the same time and it's a good idea to lock down the mortgage interest rate at this time.

At the beginning of home construction, the borrowed money from the construction loan is placed in a bank account and checks are written, drawing on this money. You only pay interest to the bank on the money used. You do not pay principle, that happens when it converts to a mortgage, after the home is built.

Just as there are different kind of mortgages, there are variety of construction loans with different variables.

• Construction loans are short term loans that can last between 6 months and 2 years depending on terms from your lender.
• Some loans are construction only or construction to mortgage loan.
• The credit score of the borrower determines the amount of funds that the banks will lend, it's not open ended.
• Construction loans are usually variable-rate loans priced at a spread to the prime rate or some other short-term interest rate.

The construction loan funds are dispersed on a predetermined schedule or upon stages of completion. According to completion and inspections more money is released. At the end of construction a certificate of occupancy is issued by the municipality allowing occupancy of the home. This triggers the end of the construction loan.