A construction loan is a story loan, which means that the lender wants the entire story of how the loan will be used before they advance the money, unlike residential construction loans. Due to this fact, the loan will not be standardized. This means that there are no guidelines to follow when underwriting the loan, unlike other types of loans like mortgages. What this translates to in practical terms is that the loan is advanced in installments. Unlike a mortgage, a construction loan cannot use a home as collateral because the home in question is not built yet. The lender advances the loan in installments in order to limit their risk.
Typically, the number of installments is around four. Each one represents twenty-five percent of the total loan balance. That twenty-five percent, in turn, is used to construct one-fourth of the home. As a casual observer can note, the fact that the loan comes in installments in some ways limits how fast the home can be built. Lenders require the borrower to build twenty-five percent of the home before the first twenty-five percent of the loan balance can be advanced. This requires the borrower to put up capital of their own to finance the initial stages of the project.
An appraiser is then sent to the construction site to verify that the home is, in fact, one-fourth done. The appraiser reports back to the lender and tells them that the house is proceeding on schedule. Finally, the lender releases the next twenty-five percent of the balance, and construction continues. The appraisal process is done by presenting legal documents to the borrower that the borrower then verifies. The appraiser takes them to the lender, who authorizes the advancement of the next installment based on those documents.
The good news is that, while construction is still happening, the only payments the borrower has to make are based on the interest rate of the loan. The full balance is not due until construction is completed. In addition, the interest payments are due only on the amount of the loan that has been advanced. As construction draws closer to completion, however, the interest rates rise to match it. This can create pressure on the borrower, especially if they are counting on someone buying the home immediately after they finish.
Obviously this process is heavily dependant on the condition of the real estate market. If the market is down and home prices are depressed, the borrower may not get enough money to pay back the loan.
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