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How Does a Construction Loan Work? (Tue Tip)

November 30, 2010

house and calculator 

For today’s tip, we have a guest post by Emma Martin on the process of obtaining a construction loan.  Emma writes for CB Structures, a family owned Construction and Engineering Company that specializes in garage buildings and pole building design.

As the name implies, a construction loan is specifically meant for those who wish to undertake the construction of a building rather than buying one that is already complete.  There are many reasons why an individual or entity would seek this type of loan, and there are actually several choices when it comes to securing such funding, from different loans to different lenders, but you may not realize that your reasons for wanting to construct a building (and your ultimate goal for your completed structure) may make a difference in not only how much money you can borrow, but what type of loan you get.  So before you go ahead and purchase a parcel of land, there are a few things you may want to consider.

  1. Your goal.  If you are a private individual, chances are you’re looking to build your dream home.  You may own land already or you may be seeking a space to erect your structure, but ultimately, you’re looking for a family home.  A company seeking a construction loan may be interested in owning office space or they may simply be in the business of building and selling property.  Whatever your goal, it will almost certainly have bearing on the type of loan you select, and it might also affect what a lender is willing to offer you.
  2. Credit score.  Your FICO score will definitely come into play any time you attempt to secure a loan, and planning for construction is no different.  A high credit rating will not only give you a better chance of getting approved for a loan, it will help you to set a budget.  Also taken into account are assets and outstanding debt, so you’ll want to try to pay off car loans and credit cards if you can (although you could also roll them into the new loan amount).
  3. Budget.  You need to start with a budget in mind.  You’d do the same for any large purchase, so do your homework before you get to the bank.  Find a piece of land you’d like to buy, get bids from contractors, and see if there are ways you can cut back while still getting what you want.  If you approach a lender with a solid plan for spending, you might have a better shot at getting the loan you desire.  Of equal importance is knowing what you can afford.  Just because you CAN get a loan for double what you think you’ll need doesn’t mean you SHOULD.  You should always opt for a 10-20% buffer for unexpected costs, but don’t take more than you can afford to pay back.
  4. Loan type.  Once you have formulated a plan, set a budget, and gotten approval, it’s time to consider loan options.  For private homeowners, the best bet is usually a 30-year fixed or 15-year fixed loan (the same type you would opt for in a home loan) because you can treat it like a mortgage rather than paying processing fees and closing costs twice (once for the construction loan and then again for the mortgage loan when construction is completed).  Those who are looking to build and sell immediately may do better with a short-term, low monthly payment loan such as an interest-only option.  This will allow them to allocate all of their resources to construction and recoup costs upon sale.
  5. Lending institution.  Rather than shopping around at local banks for a construction loan (which may not even be available), consider contacting a construction loan broker who will do the shopping for you.  They will have a good idea which lenders offer the type of loan you need and for a fee, they can probably get you the best deal in town.

 

Do you have experience getting a construction loan?  How difficult did you find the process to be?  What do you, as a construction professional, advise your clients?  Emma and I encourage you to share in the comments section below.

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Photo ©iStockphoto.com/burtongirl

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