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Updated at 2018/07/11

Construction loans to build new homes are either obtained by the prospective owner of the home or the actual homebuilder. It is important to be clear which party is securing the loan, as small-sized homebuilders may have difficultly because of capital constraints.

How Do Construction Loans Work?

These types of loans are difficult to obtain unless the borrower has previous banking history or sufficient collateral. Once obtained, these loans are typically monitored to ensure the project is completed on time and repayment can begin. Usually construction loans have variable interest rates and are tied to the prime rate; they often have higher rates than mortgages. To approve the loan, lenders generally want to see detailed plans for the home, budget numbers and construction timetables.

Once the loan is approved, the lender places the borrower on a bank-draft schedule that corresponds to the stages of the construction project. As more funds are requested, the lender has someone perform an on-site visit to confirm the project's progress is in line with the plans. If everything looks as it should, more funds are released to the borrower. During this time, it is common for only interest payments to be made on the loan. The arrangement is comparable to a credit card with a large limit that lasts until the home is built. At that point, the borrower gets a mortgage for the completed house, a portion of which is used to pay off the balance of the construction loan. It should be noted that borrowers are not required to take construction loans and mortgages from the same lender. Also, there are no prepayment penalties with construction loans, so borrowers can pay the balance before it is due if desired.

One-Step and Two-Step Construction Loans

There are two different types of construction loans: one-step loans, also called "simple-close" loans, and two-step loans. The type of loan a borrower should get depends on the type of house under construction. With a one-step loan, a borrower agrees to get the construction loan and the mortgage from the same lender. Paperwork for both are filled out at the same time. A one-step loan is a great option if the borrower is certain of the total cost of the home and the exact amount of time it will take to build. Running over cost or over schedule causes major problems as adjustments to the loan amount cannot be made.

A two-step loan splits the construction loan and mortgage into two parts. With this loan type, the mortgage does not start until the home is finished. This type of loan offers much more flexibility, especially for first-time home builders since costs and schedule can both exceed what was initially planned.

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