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How do Construction Loans Work?

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Construction loans are useful when a borrower intends to build in order to meet his specifications; rather than make do with an existing structure.

Construction loan, as the name suggests is provided for the construction of a residential or a commercial property. An individual or a company can avail a construction loan in case they lack the necessary resources to fund the construction. Construction loans can be broadly classified into two categories: 1) Residential; and 2) Commercial.

Residential Construction Loans

Residential construction loans, unlike mortgages are short term loans. During the construction period, the builder (borrower) is expected to pay only the interest on the loan. The interest is variable and is based on the prime lending rate. The amount of money the bank or the financing company is willing to lend depends on the credit score of the builder. A good credit score and a high credit limit, will definitely help his cause. The income of the borrower is also taken into account, while providing the construction loan. In case, the builder owns the land, the lending firm might consider the value of the land as the amount of equity provided by the borrower. The amount of loan is sanctioned according to the following rule: 85% of the cost of construction or the eligible loan, whichever is less. Unlike mortgages, construction loans are provided as and when construction on a portion of the house is completed. Generally, a construction loan is provided in four installments. Each installment is provided after the builder submits the necessary proof and documents that satisfy the lending institution regarding the progress on the house. The borrower does not provide any collateral, hence the stringent rules. On completion, the builder has to obtain an occupancy certificate. Residential construction loans are of the following kinds:

Construction Only Loans/Separate Construction and Mortgage Loans. In this case, the borrower obtains a construction loan for a period of six months to a year. The loan is obtained in installments. During this period the builder makes floating interest payments. The interest payments increase with every installment provided to him by the lending company. The interest payments are tax-deductible for a period of 24 months provided at the end of this period the builder occupies his

house. Once the house is built, the remaining amount is paid off by taking a first mortgage. The builder at this stage has the option to shop around for the best deal on his mortgage. He can opt for a fixed rate level payment mortgage or an adjustable rate mortgage. The disadvantage of a 'construction only loan' is that the builder has to pay twice for closing costs.

Construction to Mortgage Loans/Combination Loans. In this case the builder opts for a construction loan that automatically converts to a mortgage at the end of the construction period. There is an interest rate for the construction period and at the end of this period the builder has the option to choose a fixed or a variable rate of interest on the mortgage. Since this is a combination loan, he cannot shop around for the best deal. In case the construction period exceeds one year the builder is forced to pay a penalty.

Commercial Construction Loans

A commercial construction loan can be used for the purpose of constructing apartments, warehouses, industrial buildings or retail centers. While sanctioning a commercial construction loan, the following ratios are analyzed by the lending institutions:

Loan to Appraised Value Ratio. In order to ascertain the profitability of the investment, the lending institution calculates the Loan to Appraised Value Ratio. A lower ratio is desirable, since a low ratio would mean a higher appraised value. Of course, we are trying to appraise a property that is still under construction.The lending institutions, thus prefer the Loan to Cost ratio. A low ratio would indicate a person's ability to finance a large portion of the cost.

Debt Service Ratio. This is computed by dividing the net operating income from the investment by the annual mortgage payment. A debt service ratio that exceeds 1.25, is desirable.

Net Worth to Loan Size Ratio. This ratio should be greater than, or equal to one.

There are many lending institutions willing to provide residential and commercial construction loans. The choice of the loan would depend on the interest payable and the other terms and conditions of the loan. The builder should compare the rates and terms of the loan before settling on an appropriate construction loan.

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