Construction Loan Questions and Answers

  Frequently Asked Questions

1- Construction Loans seem to follow stages. What are they?

   Though this may vary from project to project, there is are logical steps at which construction loans guidelines allow disbursements to be made.

 
   The eight main stages of construction are:

• Site Excavation, Grading and Foundation.

• Framing, Walls and Roof

• Mechanical Systems,. Plumbing and Wiring

• Exterior Wall Finishing

• Drywall Installation

• Interior Trim, Cabinets and Fixtures

• Painting, driveway Installation and Certificate of Occupancy

2- What is Loan to Value?

 
   Just like a purchase mortgage loan Loan, construction loans are made on the bases of Loan To Value, commonly abbreviated as LTV. This is the number obtained by dividing the Loan Amount by The Value of the Property.

  
   For example, if you purchase a property for $100,000 by putting $20,000 down and obtaining a $80,000 loan, then your loan’s LTV is 80%.

  In the case of construction loans however, Value refers to the appraised Future Value of the Property.

 
3- What Are The Main Components of the Actual Costs of Contraction?

   For the purposes of construction loans, the Total Cost is defined as the total of Land Acquisition Cost, (or present value if obtained more than 12 months ago), and the Total Construction Cost.

 
   The Construction Cost consists of two components, Hard Costs and Soft Costs.

  
   Soft Costs are the non physical expenses, such as: Transfer Taxes, Origination Points, Mortgage Insurance (if applicable), Overhead, Architectural fees, Permits, Title Insurance, Appraisal Fee, Hazard Insurance, Course of Construction Insurance, etcetera.

 
   Hard Costs are the physical items, such as: Land Cost/Value, Site Prep/Grading, Septic tank/Well, Construction Contract, Cost overruns, etcetera.

 
   Reserves are the amounts calculated mainly for two purposes. First component of the reserves is normally equivalent to 5% of the hard costs and it can be used in case of cost over-runs.
   
   The second component of the reserve in construction loans is calculated based on a percentage of annual payments deemed enough to cover the monthly payments of the construction loan. 

 
   Construction Loans are calculated based on the above and the combination of closing costs, pre payments and inspection fees.

 
4- What if The Project Costs More Than Estimated?

   Cost Overrun is a legitimate concern, whether caused by unforeseen circumstances or last minute changes.

   When calculating the Total Cost, most construction loans will need the addition of a 10% of the contract amount as a contingency reserve. This contingency can be used in case of cost over runs.

 
5- What is Title Insurance?

 
   Simply put, it is the insurance a property owner obtains (required by lenders) at the time of purchase, to ensure the proper transfer of Clean Title.

 
   In the case of  Construction Loans, this works slightly different in that the title search is updated during the course of the construction.

 
6- What is Course of Construction Insurance?

 
   Homeowners normally obtain Hazard Insurance (Required by lenders). In the case of construction loans an additional insurance policy is required.  

   This policy, known as Course of Construction Insurance, covers the owner against any claims that may arise out of the construction process, such as personal injury or damage to other property.

   Course of Construction Insurance, is sometimes paid by the General Contractor, depending on the terms of the contract negotiated.

 
7- How Do The Loan Payments Work?

   Normally it is assumed that the construction period will be 12 months. However this may be extended to 18 months.

   Normally the one time close construction loan is originally written for a 31 year term – 1year construction period and a 30 year Permanent Loan.

   In construction loans, Interest is paid only on the amount Drawn at any one time, calculated as simple interest. No principal payments are calculated.

 
8- Why Does The Contractor Have To Be Approved?

 
   Construction loans will typically include contractor approval. This protects the interests of both the Borrower and the Lender.

 
   The process takes 3-5 days, and consists of credit and credentials check. This should not be interpreted as a guarantee or a warrantee of the contractor’s quality of work or performance.  

9- What Does An Appraiser Appraise?

   At the inception of construction loans, there obviously is no building to go by. However there is a plot of land and a set of drawings.

   There are also recent sales of similar properties in the area, that the appraiser uses to deduce a value for the completed project.

 
10- What If The Appraised Value Is Lower Than Expected?

   Construction loans, just like their counter part for buying homes. are  dependent on an appraisal report.  

Most Appraisers do a very good job of coming up with a fair value.  

   However the borrower must appreciate the fact that the appraiser is there to protect everyone’s interest.

   If the property won’t appraise then it is probably the wrong property for the area.  

 
11- Does The Appraiser Guarantee The Value of The Completed Project?

 
   Absolutely not!

 
   An Appraiser prepares a report on the comparable value of the property based on the market conditions at the time of the report. Construction Loans are made on the basis of that report.

 
   Market conditions may very well change, and result in a higher or a lower value, by the time the project is completed.

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Also see:
How is a construction Loan Calculated?