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What is a Construction Loan?

Sep 7, 2021 General

Dreaming of building your custom home, but don’t know where to start? The building process is already stressful enough without having to think about the type of loan you need or how to manage the complex construction process and draw schedule. BankSouth is here to answer your questions and help simplify the entire program.

1. What is a construction loan? 

A construction loan is a short-term line of credit to finance the building of a new home or remodeling of an existing home. The funds are paid directly from a bank, like BankSouth, to the builder or contractor in installments for each phase of the building project, known as the “draw schedule”. At BankSouth, we have an inspector who verifies the completion of each phase of construction before a draw from your construction loan is made to pay your builder or select subcontractors.

2. What is the difference between a construction loan and a mortgage? 

Once you own your lot, a construction loan is the first type of loan you might acquire when building your own house. It is set up as a line of credit, and you only pay interest on the amount drawn on the line each month. Mortgages are set up as installment loans for a fixed period and can only be closed once your home is complete.  Because construction loans require a higher level of management than a mortgage, they usually have higher interest rates and down payments.  

3. How much money do I need to put down? 

Most banks, including BankSouth, require borrowers to invest 20% equity into their home.  

This can be calculated by adding up your total home cost, including the land. Total project cost is best calculated by adding your lot value/price + cost to build. For example, if you paid $100,000 for your land, and your construction budget is $300,000, your total project cost is $400,000, so you would need to invest $80,000 total into your project. This can be paid upfront in the lot if you paid cash, or it can be done in two steps, 20% down on the land ($20,000) and you would bring another $60,000 when you start construction. 

4. Do I have to sell my current home before I build in order to access the equity in my house? 

Not necessarily! At BankSouth, we can work with you in order to pull out equity from your current home on either your lot loan or your construction loan, so you only have to move once!  This is sometimes referred to as a “bridge loan”.

5. Which should I consider first: my Construction Loan or Builder/Contractor? 

Either, depending on where you are in the process. Some people want financing pre-approval so they know how much they can afford when building their home. Others have a contractor and detailed building plans before they start the process to obtain a construction loan. It is important to check with your financial institution because some banks require building plans before they will approve a construction loan. Here at BankSouth, we offer customers the ability to get pre-approved before they have official building plans or a contractor.  

6. How does a construction loan fit with a lot loan? 

If you don’t have a lot yet, you would first obtain a lot loan when buying your property (or pay cash). Once you do have a lot, both your lot loan and construction loan will ultimately get rolled over together into a permanent mortgage (we call this the “Complete Home Financing Package”). 

To summarize the process: 

Lot loan → Construction loan → Extended Rate Lock → Permanent mortgage 

Extended Rate Lock is available when you obtain a Construction-Perm loan with BankSouth. This is a 12-month rate guarantee on your mortgage interest rate, so you don’t have to worry about rates rising during the life of your construction loan. 

7. What is repaid during the construction period? 

You make interest-only payments during the life of the construction loan. Principal plus the interest on your mortgage gets repaid during the life of the mortgage, which is typically 30 years. The principal is the amount of money you borrow from the bank, and interest is the fee you pay for having the loan. 

8. How long does a construction loan last? 

Construction loans typically last for 12 months but can be extended for a longer term if necessary. Even if the physical construction lasts less than 12 months, your construction loan still lasts the full period. This is beneficial for many customers selling their previous home because it gives them time to sell before making full mortgage payments on their new residence.   

9. How do I manage my building process? 

Once you have your construction loan and building plans, it’s time to get started building your dream house! You may be wondering how you will manage your building process. The management process varies across financial institutions, but here at BankSouth we have skilled employees and cutting-edge technology to keep you organized and informed. To read more about how we will help you manage your building process, read our blog post here. 

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