How Does Interest on Home Construction Loans Work?

In most areas across the U.S., the housing market is a seller’s market. The demand for homes is up - and the supply is rather low. Many are turning to new construction so that they have a better chance of getting the home they are looking for. That means, more and more new home buyers are seeking home construction loans to get the process started.

Since construction loans are a bit different from conventional home loans, it is important to gain an understanding of how they work - especially when it comes to the interest and payment during the building process.

What Are Construction Loans?

Home construction loans are short-term, often higher-interest loans that give you the money you need to build your new home. Unlike 15- and 30- year mortgages, construction loans typically last about a year - enough time to finish construction. A timeline for the completion of the project is required, as well as the plans and budget.

The plans are reviewed and, if approved, the loan money will come to you at each phase of the construction project. As one phase is completed, more money will be released, etc. This continues until it is finished. An appraiser and inspector are often hired by the lender to monitor the home’s progress.

Construction loans will cover the cost of the land, the building materials, contractor fees, and permit fees. It may also include appliances, plumbing fixtures, and even landscaping. And there is often a little wiggle room in the loan money for certain changes or upgrades that may be decided once the plans have begun to move forward.

While the terms may vary, it is common for construction loans to convert to a traditional mortgage once the construction has been completed.

How Does Interest Work on Home Construction Loans?

Taking out a mortgage on a property can usually land you with a pretty low - or decent - interest rate. The reason being is that the loan uses your new home as collateral. In other words, if you stop paying on your loan they can foreclose on the property - and take your home in an attempt to get their money back. With a home construction loan, there is no home to use as collateral. So, to protect themselves, banks will usually charge a higher, often variable interest rate as they consider it a much greater risk.

Remember, you do not receive a lump sum payment but rather can make draws as if a line of credit at certain stages throughout the construction process. This means you aren’t going to have a set payment amount that you have to pay each month as with a traditional mortgage - especially when you don’t have access to all the money.

It is quite common for banks to only require interest to be paid on the funds that have been drawn rather than on the full amount of the construction loan. What’s more is that, depending on the lender, you may only be required to pay interest-only payments during the construction process. Then, once it is converted into a mortgage, you will begin to make your regular payments on both principal plus interest.

Construction Loan Experts at District Title

Home construction loans are much different than traditional mortgages - which leaves many buyers with a lot of questions. We’ve closed literally thousands of construction loans worth billions of dollars. Having an experienced team to guide you through the process and provide all the answers you need can be a tremendous relief.

At District Title, we are here for you. Contact us today at (202) 518-9300.