Construction Loan: First Steps

Though we didn’t involve a bank in our land purchase, since we had cash on-hand, we needed to secure a construction loan for the build. Construction loans work a lot differently than mortgages, since the bank wants to keep tabs on the construction to ensure something is getting built that the bank can foreclose on and sell if things go sideways. So most construction loans are setup as a series of “draws,” where the contractor requests money for a task, like framing, and the landowner approves of the withdrawal, and then the loan officer approves of the draw as well and releases the money for framing. Some banks structure the draws in the form of a monthly allowance. Others structure it based on discrete tasks or phases of the construction.

Then, the bank usually keeps tabs on the build, stopping by the site to make sure that, for example, you’ve actually used the excavation money for excavation before they release the money for concrete work. If the loan officer shows up to a blank piece of dirt, it’s an indication that the contractor has used the money for some other purpose, which is bad for everybody. The homeowner in particular.

Construction loans are also for a short term – a year or two – since they’re only meant to finance the construction process itself. Once construction is complete, most new homeowners will get a traditional mortgage on the home, and use that money to pay off the construction loan. Usually, construction loan payments are interest-only during the construction period.

We called around to a few banks to see what they would need from us to qualify for a loan. It was the usual money stuff for a standard mortgage: tax returns, account balance statements, etc. But they also needed a full set of plans and a budget for the build. They would then have the project appraised to ensure that when it was all done, the finished building would be worth enough to serve as security on the loan. We didn’t have the plans yet, so we couldn’t get the construction loan yet.

But, since we could get the banks the money information, they could pre-approve us for the loan, pending later approval of the plans. We went forward with that, and the two banks that would go through a pre-approval process approved us for a $600k construction loan, which included the “soft” costs of the build, like architecture fees, permit fees, etc. So far so good, since that was our target budget.

One bank also offered a “single-close” product. Instead of the separate construction loan and mortgage, like I described above, their construction loan would automatically convert into a mortgage at the end of the construction process. The good news would be that you pay a single set of closing costs. The bad news is that they couldn’t convert the construction loan to a fixed-rate mortgage, they would only convert it to an Adjustable Rate Mortgage, or ARM.

Though interest rates had gone up somewhat as of the summer of 2019, they were still near historically low levels, and we figured we weren’t interested in an ARM given how those have gone for people in the past (hello 2008 real estate crash). So we were on the market for a traditional construction loan. But for that, we needed plans and a budget.