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A construction loan basically means a financing agreement for a lender to provide the funding for a site to undergo construction works.
This should not be confused with renovation loans that deal with home design. Construction loans are for home building.
A borrower or land owner will usually have two options to select from.
Either go with a one-loan agreement, or a two-loan package.
A one-loan arrangement will mean that the funding is granted by the lender, and it converts into a mortgage once building works have completed.
A two-loan package refers to two separate loans where one is sort of a working capital loan for construction, and when the works are completed, a second loan is taken to pay off the first.
The reasons why construction loans cannot be structure like typical term loans is that:
- A lot of money is at stake
- Lender need to ensure funds are used for construction
- Lender needs to protect itself from failure to construct
- The full potential value of the land improvement can only be realized after completion
The amount that a lender would approve will depend on the appraisal of improvements that will be done on the site.
Once a value is estimated, will the lender be able to determine the loan amount.
Sometimes a land owner might let the builder arrange it’s own financing.
In this case, the building will take over the title in order to obtain it’s own financing… which the owner might not agree to.
This is why it’s important to carefully screen any builder you are considering to hire. Because if they are not financially strong enough, there is every chance they would never finish the job due to lack of funding.
Once a property has completed construction, the construction loan is typically reverted to a regular home loan.
Land owners and home owners should remember the clearly express this to the bank when initially taking up the construction loan.
Otherwise it might remain the same, creating a unique charge on the property that can cause problems in the future when refinancing or selling the property.
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