Construction loans are a specific type of short-term, higher-interest home loans. It is used specifically to help finance the development, expansion, or renovation of a residential property on a plot of land.
When building property, unexpected things can happen and unanticipated expenses can pop up. The lack of property for collateral is also an issue for lenders. As such construction loans are considered riskier for lenders, hence they tend to charge higher interest than standard mortgages. There are also higher down payment requirements for construction loans. This can vary between 20 to 25% on average depending on the lender and the borrower’s credit score.
Typically the term for a construction loan is one year on average. By the end of the term, a home must be constructed on the property, and proof of occupancy should be issued by a certificate of occupancy. In order for a lender to approve a construction loan, a detailed construction timeline including in-depth plans and a budget is required.
During the construction phase, the borrower usually only pays interest payments. Once the home is complete, the borrower will usually take a standard mortgage to pay off any remaining interest and principal payments. Alternatively, the borrower can pay cash or apply for a different type of loan to cover any outstanding payments.
The lender on the other hand tends to payout portions of the construction loan based on building milestones. As an example, this can be the foundation of the home, framing, and plumbing milestones.
Some lenders require that balance, both principal and interest be paid by the end of the term.