How do construction loans work?

Construction loans can be difficult to obtain. It is easiest to get these loans when you have collateral such as a home or property that is already paid for as well as good credit. As the old saying still goes, "people need money to make money". If you do not have a good lending relationship with businesses you deal with on a regular basis, be prepared to pay out more for lending fees. 
There are two types of construction loans. The two loans are referred to as the "construction only loan" and the "construction-to-permanent mortgage loan". Both loans are for non-commercial properties. 
The first loan type is the construction-to-permanent mortgage loan which includes the costs of the construction project and mortgage fees. This loan works well with deferred payments for one year. Interest fees and rates vary with loan 2. There may be a penalty fee for projects that are in need of an extension for more construction that extends past one year.
The 2nd loan is the construction-to-permanent mortgage loan which includes the mortgage costs of the construction project and construction project costs. Interest rates vary with this loan. One lender typically works with this lending plan from start to finish.     
                                 
Step 1.                                       Apply                                 
Construction loans are best obtained through a local bank or reputable credit union. Construction loans tend to be short term and monitored by the banking source giving the customer the loan to make sure the loan is paid off in a timely manner as agreed to between the lender and borrower. The percentage rate for these loans is approximately 5% to 20%.
Step 2.                               It starts with a  story.
The lender requires a detailed chart of the borrower's building plans which will also include a detailed budget for the construction. This building plan chart is called a story. Once approved a bank draft is created also called a draw.
 
 Step 3.                                The draw         
The draw is a scheduled chart that makes sure the borrower is having the designated project worked on on a timely schedule. Payment to the funding source lending the borrower money is based on the scheduled draw. The banking source lender will send someone out to check on the construction project as scheduled on the draw to make sure everything is working out with the building and up to par. The building time for a new construction project takes approximately one year. 
                                          Last but not least, project completed.
When the project being built is completed full payment is due. Land already owned by the builder surrounding the properties or property being built can also serve as payment to the lender. This is called equity.  Full payment to contractors is due at completion time called the principal balance.  
Sometimes payment can be deferred for one year as with the construction-to-permanent mortgage loan. After the property is inspected, a certificate-of-occupancy follows. The borrower's loan liability will typically roll over into a mortgage, ideally in an arrangement where the borrower pays closing costs once. 

Construction loans are most commonly used by prospective owners to build their dream home or to build a new piece of commercial real estate. There are two types of construction loans, which are very different from each other: Commercial construction loans are typically very short, lasting just a few years, while custom homes are typically built with a loan that acts just like a mortgage.

The two types of loans also have very different requirements, though the process to obtain them is similar:

1. Create a plan for building the property
2. Obtain approval from a lender
3. Find a builder
4. Build the property
5. Final appraisal and inspection

When asking for a construction loan, the most important question will be what the property is used for. If you want to build a commercial property, then a lender will require a detailed plan showing how you will you will repay the loan, such as a business outline or a plan for selling the property. If you want a dream house, then the lender will usually require that you have excellent credit, be capable of making a 20% down payment, and display a large regular annual income. 

Because many construction projects wind up being cancelled or abandoned, lenders often require much higher collateral than for a normal loan. Lenders will also require a more in-depth examination of your personal finances and credit history. Still if you can meet the requirements, then you should be able to find a lender for a construction loan, even in light of the recent upheaval in the mortgage market.

It’s important to note that nearly all construction projects come in over budget. You should therefore plan ahead when deciding how much to ask for in a loan, considering potential pitfalls or additions you might eventually want. You should also be very cautious when selecting a builder. If, for instance, you ended up with a less-than-reputable builder, the final appraisal of your property could wind up being less than what you borrowed, meaning you will owe more than your new property is worth. In that situation, your lender will not be willing to cut you a break; you will still have to repay the full amount of the loan.