Most people, when they decide to build a house or add significantly to an existing home, need financing in order to pay the builder. This kind of financing is called a construction loan. The usual providers of such loans are commercial banks in the communities where the construction projects are located. Construction lenders follow established guidelines that cover loan approvals, loan amounts, disbursements to contractors, and inspections. Construction loans are normally repaid from the proceeds of long-term mortgage loans.
The construction contract is the basic document supporting the building project. Signers are the owner of the house to be built and the builder or general contractor. According to the Construction Loan Center, the usual contract spells out the responsibilities of each party and sets the dates for completion of construction and occupancy. It also gives the amount of the contractor's total payment and the payment method. If an architect will be involved in the project, her responsibilities are outlined in the contract.
Lenders base the amount of the construction loan on the projected value of the house after all work on the project has been completed. Banks generally use one of two methods to calculate the amount they will advance for a construction loan. Some use the total estimated cost of construction, including fees; others use the appraised final value of the house. Loan amounts might be between 70 percent and 80 percent of either total cost or appraised value.
The loan agreement between the bank and the project owner will contain a schedule for disbursing funds to the contractor during construction. When the contractor completes a phase in the construction process, he will request that the bank disburse a certain amount. Upon verification by the bank's inspector, the bank will advance funds. This procedure continues until the project is complete.
When the contractor declares that he has completed his work, the bank's appraiser conducts a final appraisal to certify that the final value of the house is as expected. If the local government inspector is satisfied that all is in order, he issues a certificate of occupancy. Next, the bank and the owner close on the permanent mortgage loan. The proceeds of that loan pay off the construction loan.
Charles Crawford, a former commercial banker, has been a business writer in New York since 1990. He has produced marketing materials for an executive outplacement firm, written the quarterly newsletter of a medical nonprofit organization and created financing proposals/business plans. Crawford holds a Bachelor of Arts in English and a Master of Science in international affairs from Florida State University.