Understanding and Dealing with Construction Loans

What is a Construction Loan?

A construction loan is money borrowed from a lender to construct a building.  It is different from a normal loan in a few ways.


(1) The lender does not lend all of the money to you at once.  Instead, there is a construction fund from which the lender will pay for the construction based on the progress of construction.


(2)  Part of the loan includes a contingency fund to account for change orders and other unanticipated expenses.


(3) The contingency fund typically includes an interest reserve, that is intended to account for the interest on the loan during the course of construction.


(4) After the construction is finished, the amount of money that has been loaned is then converted into what is called a permanent loan, which is usually for a longer term, and closely resembles the typical homeowner's mortgage.


What are the important points to negotiating a Construction Loan?


(1) Employ a lender who has a lot of experience in providing Construction Loans.


(2) Find out what kind of support the lender will provide during the construction process.  Most lenders will conduct periodic inspections to determine the progress of construction, and will handle progress payment requests from the contractor.


(3) The planned duration of a construction loan is critical.  Always request more time than you think it is going to take.  Construction is a very uncertain process, and is subject to many events that can delay the progress of work.  You can also ask the lender to provide you with agreed upon extensions of the time on the loan.  You need to do this up front.  It is much more difficult and expensive to request an extension of a construction loan beyond the agreed upon time.  For example, extending the term of a construction loan will usually require a new appraisal.  Particularly if market conditions are in decline, this can result in increased loan costs, reduced loan amounts, and even a demand that the borrower contribute more money to the construction project.


What can the Borrower Do to Ensure a Successful Project?


(1) Know your contractor

The contractor is the keystone to supporting a successful project.  You need an experienced contractor with a record of reliability, financial stability and quality workmanship.

(a.) Get a list of references and visit with the owners.  Ask how construction went and what they would have done differently.  Ask how much the construction cost varied from the amount originally promised.  Inspect the quality of the construction carefully to see if it meets your expectations.

(b.) There are also resources online that will help you.  In California, the Contractors State Licensing Board has guides to hiring contractors, and an easy way to search for your contractor's licensing history.  The website is www.clsb.ca.gov.  You can also check the local court records to see if your contractor has been involved in any lawsuits about construction defects or making payments to subcontractors.


(2) Make decisions on what your project is going to be like before construction starts. 

Most consumers allow a construction project to start with very general design drawings.  They do not consider things like finishes, hardware, appliances, flooring and other items that can greatly affect the total cost of a project.  When it comes time to make these selections, the number of decisions can be overwhelming to most consumers.  It is not unusual for consumers to stop making decisions at some point during a project because there are so many decisions to be made.  This can greatly impact the completion of a project.


(3) Watch out for "allowances" in your construction contract.  

If you have not told a contractor specifically what type of flooring or appliances you want to use, contractors often put in their bids an "allowance" for the item that will change based on what you ultimately select.  Many times, these allowances are used to make the contract price seem much lower than it actually will be.  The result is that the actual construction price will be much higher than anticipated.


(4) Try to avoid changes in the work

It is very common for consumers to change their mind in the middle of construction about the location of a wall, expanding a room, or other changes.  Changes during the course of construction are usually very expensive, and can result in unintended consequences.  Moving a wall, for example, may require a structural engineer's approval, and may affect the routing of electrical, plumbing or other items.


(5) Make sure everyone is getting paid on your project. 

Contractors usually hire subcontractor to perform specialty work, such as electrical, plumbing, and roofing.  They also order a lot of supplies, like lumber, concrete, windows and siding.  All of the people providing services or supplies potentially have the right to record a lien on your home to compel payment.  If a contractor runs into financial problems in the middle of a project, the consumer can be caught having to pay again for work he or she thought was already paid for.  It is a good practice for consumers to keep track of any notices received, and make periodic calls to subcontractors and materials suppliers to find out the status of payment.  Also, there is a process for receiving lien releases that can greatly reduce a consumer's exposure to claims.


(6) Hire an expert to observe construction

Mistakes in construction are common, and can happen for a variety of reasons.  Correcting a mistake after construction is finished is much more costly than catching it early.  Hiring an experienced contractor to help observe construction can save a tremendous amount of money.  In addition, a contractor who is on your side can help you decide whether a request for additional money from a contractor is reasonable.


(7) Consider obtaining a Performance and Payment Bond

A performance bond is a promise from a third party surety that the construction project will be completed.  A payment bond is a promise from a surety that the people providing work, labor or service to a project will get paid.  Obtaining a Performance and Payment Bond (they are usually provided for a single premium) protects an owner against the risks presented by a contractor failing to complete construction or making payments to his or her subcontractors.