Construction Loans: The Good, the Bad and the Ugly

Sound like a good way to get your paws wet in the real estate investing scene? Though construction loans do offer some great benefits, they are quite a bit more involved than conventional loans. Today I'll present a little overview to help you familiarize yourself with construction loans before you dive in and track your muddy paws all over that freshly installed carpeting.

To begin, construction loans are usually "story loans". Basically, the lender needs to know what exactly you want to accomplish, why you want to do it, and how you intend to accomplish it before they can recommend a program and approve your loan. For example, if your plans are to live in a property for a while after the rehabbing is completed, your options and rates would be different from an investor who's looking for a quicker sale.

Before you approach a lender for a new construction loan you should have the "story" of your project prepared and ready to explain. The terms of the construction loan are based on several aspects like the background of the borrower, status of the economy, structures surrounding the area, etc. Properties may be titled in the name of corporations, partnerships, limited liability companies, and less often, in the names of individuals.

Construction loans are usually variable-rate loans priced at a spread to the prime rate or some other short-term interest rate. Unlike a mortgage, the loan isn't meant to be around for a long time. Most experts advise that the best time to take out new construction loans is at a time of recession. This is because at the time of recession the rates would be down so the new construction loan would be available at lower interest rates.

Once you get through the loan application process, you will begin to see the benefit of such a loan. First off, interest only means small monthly payments, verses a full blown monthly mortgage payment which does many rehabbers in when unforeseen setbacks attack. Construction loans work similar to other loans, except that only a portion of the loan is released at a time; the money is released in stages as the work gets completed according to the budget. You, the contractor and the lender establish a draw schedule based on stages of construction, and interest is charged on the amount of money disbursed to date. The largest amount that can be taken out with a construction loan depends on the lender, but is calculated using factors such as the total cost, type of property, stabilized value of the property at the time of completion, equity that has been invested, etc. Lenders usually opt for 10-20% of the total costs to be funded by the equity of the borrower.

Many homeowners use construction-to-permanent financing programs where the construction loan is converted to a mortgage loan after the certificate of occupancy is issued. The advantage is that you only have to have one application and one closing. You may be willing to pay a higher rate on the construction loan if you're doing construction-to-permanent financing and can get better mortgage terms or a longer, better rate lock from your lender.

Because construction loans typically require interest-only payments during construction, this is a healthy option for those of you who may not quite have the capital (down payment, a few months of mortgage payments, and funds for the actually rehabbing to be done) available. However, because of the way the funds are overseen and distributed, you really have to be realistic with the timetable you propose to the bank when applying for your loan. With construction loans, there is very little room for error.

So if you're willing to get your paws dirty and tackle the extra paperwork construction loans require, a construction loan may be the creative option you've been waiting for to finance your project. It's also a great option for those of you who might have found that really awesome house that has heaps of potential, but is currently a heap of unlivableness. A construction loan might afford you the time and money to rehab the house to livable condition and then convert the loan over to the mortgage of your dreams, while putting on all the finishing touches.