Understanding Construction Loan Financing on the Path to Your Dream Home

The Parade of Homes presented by the Builders Association of the Twin Cities is for dreamers, home buyers, and home remodelers. From townhomes to luxurious single family homes, there are many residences to review as you dream up your new home. A common question as you make that dream a reality is what to expect on financing your new home’s construction and how does the construction loan work?

What is a construction loan and how does it work?

A construction loan is different from a traditional, permanent home mortgage (15 year fixed rate or 30 year fixed rate) you would put in place on an existing completed residence. A construction loan is a straight line of credit whereby you have a fixed dollar amount available and can only draw as the funds are needed on the line of credit. The proceeds will be used to build your home and the line will not revolve like a home equity line of credit or credit card would. This is an important distinction. A quick outline of some additional terms to be aware of:

• Cash Equity into the project. The lender will be looking at how much cash you are requesting to invest in your home and/or how much you may already have in a lot you previously purchased.
• The length of the loan is generally six to eighteen months depending on size and complexity of the home being built. For example, if it’s a traditional construction project ($417,000 or less) it will generally take 12 months to complete, but if it is a jumbo construction loan on a luxury home, $1 million or more construction project, it may take 18 months to complete.
• The interest rate will be either variable or fixed, depending on the lender, and is generally higher than the permanent mortgage given the additional risk and monitoring of a new construction project.
• The payment will be interest only during the term of construction.
• There will be additional costs to monitor the advances on the line of credit whereby payments are made to the contractor and subcontractors during the construction of the project. It is important that this process is monitored closely to reduce the likelihood of a mechanic’s lien being put on the property.
• Other standard closing costs will continue to apply (appraisal, title work, etc…)

What should you expect when discussing your project with a lender?

Your builder may have directed you to a lender they are familiar with or you may have researched a local lender to make application on a new construction loan for your residence. At our bank, we are transparent on the process and want to outline expectations to allow for the most efficient and effective financing process so you can focus on the excitement of working with your builder on the completion of your new home.

It is important to be prepared in the application process for a construction loan or jumbo construction loan. As a starter, the bank will expect:

• You have prepared or can prepare a personal balance sheet with account statements to verify your cash available for the project, your savings, and other details on your assets and liabilities
• Verification of Income. Your lender will want to verify your income with your W-2, tax returns, and recent pay stubs.
• A home site has been located and is either purchased or under contract
• Final house plans and design for your new home are completed and you have already contracted with a reputable home builder who will build the home.
• To know your builder’s experience in building the type of home you are requesting so that it can be comfortable the builder can finish the home, organize the timing, and keep the project within budget.

Lastly, the bank will want to understand your plan after the construction phase of building your home, for instance, if you are looking to refinance into a secondary market permanent mortgage at completion or considering a portfolio mortgage product with the existing bank.

Building a new home is an exciting time. As a lender on jumbo construction loans and single family construction loans, we try to provide great service with reliability and certainty. We are fortunate to have a lender on staff, Tom Kleinschmidt, who has extensive experience in financing many homes and businesses over the years in the Minneapolis/St. Paul Metro area in both a permanent mortgage and construction loan capacity.

We have invested in expert people, systems, and industry knowledge that make us a market leader in a field often dominated by very large banks. If you or your Minneapolis/St. Paul Metro Area closely-held business, nonprofit organization, or real estate company could benefit from a bank that delivers specifically for you, please give us the opportunity to review your banking needs. We are committed to making our clients successful. Your success is our business!

Security Bank & Trust Co. is a Member FDIC and Equal Housing Lender.