How Construction Financing Works
Construction lending differs fundamentally from financing an already completed home.
At closing, the final house may not yet exist. The lender therefore must evaluate the plans, construction budget, builder, land and expected completed value.
Loan proceeds are generally controlled and released progressively as construction milestones are reached.
Land and Existing Equity
The borrower may already own the land or acquire it as part of the transaction.
Depending on the program, existing land equity may contribute toward the borrower's required investment.
The value of the land, existing liens and total project cost all become part of the financing analysis.
Plans, Budget and Builder Review
Before construction financing is finalized, the lender typically requires sufficient information to establish what will be built and how much it should cost.
That can include architectural plans, specifications, a construction contract, itemized budget and builder information.
Changes after approval can affect both the budget and financing, so realistic planning is important.
Construction Draws
Unlike a standard purchase mortgage, the entire construction budget is generally not simply handed to the borrower at closing.
Funds are released through draws as specified work is completed and verified.
The borrower and contractor should understand the draw process before construction begins so project cash flow can be managed appropriately.
Permanent Financing After Completion
Construction financing must eventually transition into long-term financing unless the property will be sold or otherwise paid off.
Some programs combine construction and permanent financing into one structure, while others require separate permanent financing after completion.
The permanent-financing strategy should therefore be considered at the beginning of the project.