Are you wondering what’s a construction loan? A construction loan is a short-term loan that provides funds to construct a real estate property. In these types of home loans, the funds are available to the borrower in instalments or progress payments rather than a lump sum. The borrower can use these funds as needed throughout the building process of the property.
Since the loan is short-term, the interest rates are high. The funds can be used to cover the property’s construction costs from the start till the end. Usually, people use this type of home loan before obtaining a long-term loan, as the former is for short-term, mostly one to three years. If you want to learn more about construction loans, here’s everything you need to know!
How does a construction loan work?
Once the borrower has checked their home loan eligibility, they can apply for a construction loan at a bank or financial institution. The bank will provide funds to the borrower so that they can start the construction process or for completing major renovations on their property.
The lending institution provides funds as the licensed builder builds the property and progresses to the next stages. Throughout the construction period, the funding from the financial institution is according to the stages of construction. During the construction loans term, the borrower has to pay interest only to the lender. The following are the construction stages and an estimate of funds for various stages:
1. Slab
This is the first stage of the construction of a property. During this stage, around 15 to 20% of funds are required from the total amount of the home loan. At this stage, the base of the house is laid.
2. Frame
Once the slab stage is completed, the lender releases funds for the second stage. In this stage, the builder creates a frame and layout of the house. The funds required at this level for building plans are 20% of the total home loan amount.
3. Lock-up
During the lock-up stage, the builder constructs the exterior of the home. The builder instals doors and windows and constructs roofs and external walls. At this stage, the funds required are 20% of the total home loan amount approved for the construction loan.
4. Fit-out
This is the most expensive stage of the construction process. In this stage, the builder creates the final structure by installing fittings and fixtures. These include switchboards, plumbing, flooring, and lights. The funds required at this stage are 30% of the home loan amount.
5. Completion
The final stage requires only 10% funds of the total construction loan. During this construction stage, the builder cleans the site and makes final arrangements. At this stage, the borrower receives the final progress payment.
Construction loan vs. conventional mortgage
A construction loan is a type of line of credit. A line of credit means the borrower doesn’t receive a lump sum from the lender. The funds are available in progress payments when needed. For example, the lender releases funds according to the different stages of the construction loan. The borrower has to make interest payments only throughout the construction period.
On the other hand, a traditional home loan or conventional mortgage provides a lump sum to the borrower, which they can use at once to purchase an already constructed existing property or established property. Have a look at the following main differences between a construction loan and a mortgage (home loans):
| Construction Loan | Mortgage (Traditional home loans) | |
| Loan Term | 1 to 3 years | 15, 20, or 30 years |
| Loan disbursement | Progress payments or Instalments of funds when needed | Lump sum payment from the lender |
| Down payment requirement | 20% to 30% | 3.5% to 20% |
| Loan repayment | Principal and interest repayments | Interest repayments during construction |
| Property type | Real estate land | Existing property |
Types of construction home loans
- Owner builder construction loan
- Construction-only loan
- Construction-to-permanent loan
- Renovation loan
Example of a construction loan
Let’s walk you through an example of how getting this loan would go about:
David purchases land and decides to construct a house on it. The total construction cost is $150,000, and David doesn’t have enough funds to cover the construction project. Instead of applying for a traditional home loan, he applies for a construction loan at a bank and gets approved. The following are the details of the construction loan:
- Down payment: $30,000
- Pre-agreed Loan amount: $150,000 – $30,000 = $120,000
- Loan term: 12 months
- Interest loan: 4%
- Interest repayments: $400 per month
David has to pay $400 per month and draw funds from the approved loan amount of $120,000. However, he can’t have a lump sum of $120,000, but the funds will be available according to the requirement of a particular construction stage. Paying interest as monthly payments are easier for David as the amount is not too much.
How long does it take to get a construction loan?
Home loans for construction require at least 45 days for approval. During this time the mortgage lender will evaluate the borrower’s creditworthiness to make a decision.
What are the requirements for a construction loan?
For construction loans to work, most lenders will require a minimum credit score of 620 . Besides that, the lender for this type of home loan will also look at the debt-to-income ratio. The lower the DTI, the better the chance of approval.
Wrapping up on constructions loans
To qualify for a construction loan, the borrower must have a good credit score and a good amount for a down payment.
If you want to learn more about home loans and financing processes, visit our home finance section. We hope that now you understand what’s a construction loan! You can now apply for a loan to construct your dream home.
