Unlike a home mortgage or home equity line, a construction loan allows a property owner to borrow against future equity after the project has been completed. For instance, if the improvements increase the home value by $500,000, the lendable equity would increase by $375,000.
Homeowners apply for construction financing in much the same way that they apply for any loan secured by the property:
- First, the lender appraises the property based on the plans-which must be approved by the city or county-and detailed cost breakdowns.
- Second, the lender calculates the loan to value based upon the "as-completed" or "as-proposed" appraised value. This figure is obtained by dividing the loan amount by the appraised value. Usually, the maximum loan to value on residential construction loans is 75 percent. This means if the "as-proposed" appraised value is $2,000,000, the amount the bank would consider financing equates to $1,500,000.
- Third, the lender starts releasing the loan proceeds to fund construction once the paperwork is completed and construction has begun.
- Most lenders will require that a state-licensed general contractor supervise the project.
- Lenders won't release loan proceeds until they verify that construction materials are on site and the project is under way.
- Once they release funds, lenders start charging interest as proceeds are disbursed to suppliers and contractors during construction.
- Construction loans usually feature interest-only payments during the building period. And unlike regular mortgages, such financing usually runs just 12 to 18 months. The lenders expect homeowners to refinance construction loans for longer terms when the project is nearly complete.
