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How Do Home Construction Loans Work

Getting a construction loan can make it possible to build the home of your dreams. While the basic elements of this loan are much like any other loan, this type of loan works differently than a traditional mortgage. You may find that some construction loans are tied in with a mortgage, while others are loans only for the actual construction phase.

Function

The purpose of a construction loan is to provide a borrower with the money that he needs to pay for the construction of a house. This money can be used to pay the contractor to build the house. Many times, a construction loan is dispersed in several different phases --- this way, the lender can maintain some control over the contractor and the building process. The lender provides enough money for a down payment to the builder and then allows smaller draws to be taken out throughout the process.

Benefits

The major benefit of a construction loan is that it allows you to borrow the money that you need to build a home even though there's little to guarantee the loan. With a traditional mortgage, the house acts as the collateral for the loan itself. With a construction loan, until the house is completed, the bank is taking a huge risk. Another benefit of getting a construction loan is that it could provide you with time to shop for permanent financing once the building is completed.

Drawbacks

One of the disadvantages of this type of loan is that it typically requires a very good credit history to qualify. Even if you're able to qualify for a traditional mortgage, that doesn't necessarily mean that you can qualify for a construction loan. Another potential drawback of this type of loan is that it usually requires a large down payment. You should expect to come up with at least 20 percent for the down payment.

Types

There are two different types of construction loans. The most common type of construction loan is only associated with the construction phase and doesn't cover the long-term mortgage. Another type of loan that you can get is linked with a mortgage. With the first type of loan, you have to go through two separate closings. With the second type of mortgage, you only go through one closing, and you can save on closing costs.

Considerations

Don't fail to take into consideration how much money it takes to build a house. Even though you could potentially buy an existing house with little money down, this is hardly the case with a construction loan. You may have to have enough cash to pay for the land where you plan on building and enough money for the down payment on the loan. This eliminates many people from building their own home.

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