re: Can someone help me understand how construction loans work?

I've done this a couple times. If you own the lot you are only going to be making interest payments on the loan. They will disburse money in phases as the construction goes along, so interest payments won't be much at first. I believe its 4-6 phases depending on the contractor. After slab, framing, rough in, etc they will send you a lump sum to pay contractor. Since you own the lot, they will loan you 85% of the appraised finished product, depending on land value and cost of construction of course. So if land is worth 100k and construction is 300k you will get a loan for 340k, which means no out of pocket. Hope this helps
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I have done this many times for investment income. Your responses are good. I can add some info.


Loan amount at 85% of appraisal is likely but not set in stone. I get 90% at 1 of my banks. Appraised value is the estimated sell price and is determined largely by using 3 comps. It is not based on cost to build as mentioned by OP, unless this is handled differently for a house you intend to keep. Appraisers make mistakes and you can challenge the appraised value if it is too low. Almost every house I have done sells for more than appraised value. Some of this is due to sell prices being higher at completion than at time of getting the loan. Some of it is due to poor job by the appraiser. Research rules on what a valid comp should be with a trusted realtor. Having said that, I only occasionally challenge appraisals, but just sharing that they are seldom accurate. If you are low in liquid assets/cash, then it might be important for you to get a better loan amount. Some fees you will be charged based on loan amount, so I often let it go, but it could create the scenario of the loan not covering the cost of the build.


There is a cost approach available to determine loan amount. Some banks will loan 100% of cost; some 90%. I have 1 bank that will include interest expense and allow you to use the loan to pay those payments. So it is possible to have no out of pocket. I don't recommend doing this as it increases total cost.

I have never made a down payment on a construction loan.

Every bank I have used allows draws on the loan as frequent as every 2 weeks if that is what your builder/contractor wants. They generally try to provide good customer service to you and the builder as this is a major source of income for the bank. The first draw is normally the same day as the loan and pays for the costs associated with getting the loan. You are probably looking at $3-5k in fees and such to get the loan. Banks fluctuate an origination fee which ranges from .5% to 1% of loan amount. You will likely get hit with 1% on your first house ($2k Origination for a $200k loan). The draws are interest only payments and on the amount drawn so far. First month payment is very low and increases as more money is drawn against the loan and progress is made. Some banks may try to give you a 6 month term, but you should be able to get them to go longer. Builds that took about 6 months pre-Covid, typically take about a year now. Most of my loans are now 1 year loans. If it matures, and the house is not completed, then they will extend it but charge a few hundred dollars to do so. Upon completion of the house, they will convert it to a typical mortgage (principal + interest) if you are keeping the home. I sell all of mine. If the cost to build goes over loan amount, I cover with personal funds. There are a couple of methods to borrow additional money, though. You need builders risk insurance in place. I get mine after foundation is done and the framing package is delivered. Builder's risk is a cost replacement product. If you have damage or theft, it pays for cost to replace. Personally, I don't insure the value of the lot or things like house design and surveys that can't be damaged. I also don't insure cost to get to foundation as I live in an area that has never had an earthquake which is the only realistic scenario of needing to replace the foundation.

Hope this helps. Good luck.