How Do Construction Loans Work?
On my previous blog "How Much Does it Cost to Build a Home in Silicon Valley?",
I covered total cost necessary to build a home in Silicon Valley.
On this blog, let's discuss how to finance your home building project.
How do construction loans work?
Now that we have figured out how much money we would need to build a home in total, let’s figure out financing. Although there are people who can build a home with all-cash in Silicon Valley, most people would need to take out a loan to 1) purchase the site (traditional loan) and to 2) build a house (construction loan).
Traditional Loans v. Construction Loans
Let’s start by separating construction loans from traditional loans. A traditional home loan is a mortgage on a home, which most people have. It generally lasts for 30 years, with either a fixed or variable (ARM) rate. These mortgages are widely available through conventional banks.
In contrast, a construction loan lasts only during the length of time it takes to build the home (typically 12 months – 18 months in Silicon Valley).
Once the borrower’s application is approved, the bank is not going to give the builder the cash all at once. Instead, a schedule of draws is set up.
The borrower will be put on a schedule that follows the home’s construction stages and will typically be expected to make only interest payments during construction. For example, the borrower will pay the first 10% when the loan closes, and the next 10% after the lot is cleared and the foundation is poured. The next influx of money may come after the house is framed, etc.
Interest rates of construction loans are usually higher than conventional loans. Construction loans are riskier, because bank is lending money for something that is to be constructed, with the assumption that it will have a certain value when it is finished. Since these loans are riskier than conventional loans, not all banks offer construction loans. Regional banks are typically the best sources; I am speaking with EverBank for my construction loan. When the home is finished, however, you then need to get a new mortgage for the home that you have built, and the new mortgage will pay off the balance of your construction loan.
To sum it up, if you would like to build a home and get financing, this is the order:
Get a conventional loan from a bank to get a mortgage for the fixer upper home/site
Take out a construction loan to build your home (it does not need to be the same bank that provided your conventional loan)
When the home is completely built, get a new conventional loan for the home that you have built, and this new conventional loan will pay off the balance of your construction loan (this is called construction-to- permanent financing). In the end, you will be left with only one loan: this new conventional loan that gives you a mortgage on your newly completed home. Again, the bank that provides this conventional loan does not need to be the same bank that provided your construction loan.
In case you missed my explanation on the costs of home-building, please click this link below: