Construction Loans - How They Work

Construction Loans - How They Work

People, who are keen on building from scratch, should be comfortable with the details of construction loans and how they work.
WealthHow Staff
Last Updated: Jun 8, 2018
Construction loans may be availed for residential as well as commercial purposes. Commercial construction loans are of the following types: acquisition and development loan, mini-perm loan, bridge loan, take-out loan, construction interim loan, joint venture loan and real estate purchase loan.
Residential construction loans may be construction-only loans or construction-to-permanent mortgage loans.
How Do Construction Loans Work?
Commercial Construction Loans
Business persons can avail commercial construction loans, provided their operating history inspires confidence and provides the lender some semblance of comfort when it comes to the repayment of the borrowed sum.
The lender carefully scrutinizes the following ratios, viz. loan-to-appraised value of the property ratio, the debt service ratio and the net worth-to-loan size ratio, before sanctioning the loan.
The aforementioned ratios indicate the ability of the consumer to repay the borrowed sum. A low loan-to-appraised value ratio is always desirable from the perspective of the lender since it indicates that the appraised value of the construction is more than the amount that is lent.
In the event of the borrower not being able to repay the borrowed sum, the lender can foreclose the property and recover the amount. The debt service ratio is another important indicator that is arrived at by dividing the net operating income from the investment by the annual payment.
A debt service ratio that exceeds '1.25 to 2' is always desirable. The net worth-to-loan size ratio is also indicative of the repayment capacity of the borrower and a ratio that is greater than or equal to 1 is appropriate, from the perspective of the lender.
Residential Construction Loans
A person interested in availing a (new) home construction loan, is required to keep the lender appraised of the various steps in the process. In other words, the entire story behind the construction of the home has to be relayed to the lender. Planning the construction and submitting the necessary documents for approval pave the way to avail a home loan.
The loan, that is availed by the borrower, can be a construction-only loan or a construction-to-permanent mortgage. A construction-only loan is meant for a maximum period of 1 year. During this period, the borrower is required to make interest payments to the lender. The rate of interest charged on the loan is usually floating.
The interest payments are tax-deductible, assuming that the borrower occupies the house at the end of 1 year. After one year, the borrower hunts around for a suitable home mortgage loan.
The process of availing a mortgage at the end of the period, can be done away with by bundling the second loan with the construction loan and opting for a combination or a construction-to-permanent mortgage loan.
Once the loan is approved, the borrower can draw money from the construction fund as and when necessary. People can take a look at the construction loan agreements that are available on the internet to get an idea about what the process entails.
Given the current rate of default, construction loans have been classified as the riskiest. The rate of default on these loans has exceeded 50 percent of the sanctioned loans. High rate of unemployment, increased vacancy rates and a fall in the prices of newly constructed properties has resulted in mass defaults.
In the present scenario, it may be difficult to get a construction loan unless businesses/people are able to convince the lenders of their credit worthiness.
An important pointer to bear in mind is that you must always approach a commercial bank first for a construction loan. One rests assured about the statutory interest rates that the bank offers, them being from a reliable source.
However, only when your loan application is turned down, should you look for other measures such as approaching private lenders, where you would be adhering to higher interest rates.