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Demystifying Construction Loan Closing Costs: A Builder’s Guide

You pay closing costs on a construction loan primarily at the initial loan closing. This is when the loan is officially finalized, and funds are made available for the project’s first draw. However, unlike a traditional mortgage, a construction loan might have some closing-related fees that extend beyond that initial date, especially at the final conversion to a permanent mortgage.

Understanding Construction Loan Closing: Beyond the Basics

Construction loans, designed to finance the building or renovation of a property, differ significantly from standard mortgages. They’re typically short-term (usually 12-18 months) and have a draw schedule where the lender releases funds in stages as construction progresses. This unique structure influences how and when closing costs are paid.

The Initial Closing Costs Breakdown

The initial closing costs for a construction loan resemble those of a regular mortgage, but there are key distinctions:

Appraisal Fees: These are crucial to determine the project’s estimated value upon completion. You’ll likely need two appraisals: one of the land and proposed construction plans, and another upon completion. The initial appraisal is part of your upfront closing costs.
Title Insurance: Protects the lender (and you, if you purchase owner’s title insurance) against claims against the property. This is paid upfront.
Loan Origination Fees: This is the lender’s fee for processing and underwriting the loan. It’s often expressed as a percentage of the loan amount.
Credit Report Fees: Cover the cost of the lender checking your credit history.
Attorney Fees: If you or the lender use an attorney to review the loan documents, you’ll pay for their services at closing.
Permit Fees: Often, you’ll need to show proof of paid building permits at closing.
Recording Fees: Fees charged by the local government to record the mortgage and other documents.
Survey Fees: If a new survey of the property is required, this fee is paid at closing.
Inspection Fees (Initial): The lender might require an initial inspection to assess the property’s current state before construction begins.
Escrow or Impound Accounts: You might be required to establish an escrow account for property taxes and homeowners insurance. An initial deposit may be required at closing.

Costs During the Construction Phase

While the bulk of closing costs are paid upfront, some expenses related to the loan occur during the construction phase:

Draw Inspection Fees: Each time you request a draw, the lender sends an inspector to verify the progress of the work. These draw inspection fees are typically deducted from the draw amount. They are not technically “closing costs” but are definitely a cost associated with the construction loan.
Interest Payments: Construction loans are typically interest-only loans. This means you only pay interest on the outstanding balance during the construction phase. These interest payments are not considered closing costs.
Change Order Fees: If changes are made to the original construction plans, it may trigger additional fees with the lender, depending on your specific loan agreement.

The Final Closing: Conversion to a Permanent Mortgage

Many construction loans are structured as construction-to-permanent loans. This means that once construction is complete, the loan converts to a traditional mortgage. This conversion often involves a “mini-closing” where additional fees might apply:

Re-Appraisal Fee: To confirm the completed property’s value, a final appraisal is almost always required.
Modification Fees: The lender may charge a fee to modify the loan terms for the permanent mortgage.
Recording Fees (Again): Recording the new mortgage terms with the local government will incur recording fees again.
Points (Optional): You might choose to pay points (prepaid interest) to lower your interest rate on the permanent mortgage, although this is not a mandatory fee.

It’s crucial to understand if your loan is a true construction-to-permanent loan (one closing) or a two-close loan. A two-close loan will have closing costs for both the construction loan and the final permanent mortgage, resulting in much higher fees overall.

Navigating Construction Loan Costs: Tips and Considerations

Shop Around: Get quotes from multiple lenders to compare interest rates and fees.
Read the Fine Print: Carefully review the loan documents to understand all the associated costs and fees.
Negotiate Fees: Some fees are negotiable, especially with local lenders.
Plan for Contingencies: Construction projects often encounter unexpected expenses. Factor these into your budget to avoid surprises.
Work with Experienced Professionals: Choose a lender, builder, and real estate attorney experienced in construction loans. Their expertise can save you time and money.

Frequently Asked Questions (FAQs)

1. What’s the difference between closing costs on a construction loan and a regular mortgage?

Construction loan closing costs are similar to regular mortgage costs but include extra fees related to inspections, appraisals (often two), and the staged disbursement of funds. Regular mortgages usually involve a single appraisal and don’t have draw schedules or inspection fees tied to construction progress.

2. Can I roll closing costs into the construction loan amount?

Yes, sometimes you can roll some or all of the closing costs into the loan amount, but this will increase your overall loan balance and interest payments. It’s crucial to weigh the pros and cons and determine if it fits your budget. Be aware that lenders have limits on loan-to-value ratios, so you might not be able to finance all costs.

3. Are construction loan interest rates higher than traditional mortgage rates?

Generally, yes. Construction loans are considered riskier because the collateral (the completed house) doesn’t yet exist. Lenders compensate for this risk with higher interest rates.

4. What is a draw schedule, and how does it affect my costs?

A draw schedule outlines the stages at which the lender will release funds based on the completion of specific construction milestones. Each draw might incur an inspection fee, which is a cost you should factor into your budget.

5. What happens if I run out of money before the project is complete?

Running out of funds is a major risk with construction projects. You’ll need to secure additional financing, which could be a personal loan, line of credit, or a second mortgage. This will incur additional costs and potentially higher interest rates. Careful budgeting and a contingency fund are crucial.

6. Do I need to pay property taxes and homeowners insurance during construction?

Yes, even though the property is under construction, you’re generally responsible for property taxes on the land. You’ll also need builder’s risk insurance, which protects the property against damage during construction.

7. What is builder’s risk insurance, and why do I need it?

Builder’s risk insurance covers the property under construction against damage from fire, vandalism, and other perils. It’s essential because your standard homeowners insurance won’t cover these risks during construction.

8. What is a contingency reserve, and how much should I set aside?

A contingency reserve is a fund set aside to cover unexpected costs during construction. Aim to set aside at least 10-20% of the total project cost to handle unforeseen expenses.

9. How can I reduce my construction loan closing costs?

Shop around for the best rates and fees.
Negotiate fees with the lender.
Compare title insurance companies.
Consider paying some costs upfront in cash to reduce the loan amount.
Ensure your builder provides accurate cost estimates to minimize change orders.

10. What documentation do I need to provide for a construction loan?

Typically, you’ll need:

Detailed construction plans and specifications.
Builder’s contract.
Cost breakdown of the project.
Appraisals (land and proposed construction).
Financial statements (income, assets, debts).
Credit report.
Building permits.

11. What are the risks associated with construction loans?

Cost overruns: Construction projects often exceed the initial budget.
Delays: Unexpected delays can push back the completion date and increase costs.
Contractor issues: Problems with your builder can lead to legal disputes and financial losses.
Fluctuating interest rates: If you have a variable-rate construction loan, your interest payments could increase.

12. When does the construction loan convert to a permanent mortgage?

The construction loan converts to a permanent mortgage once construction is complete, a final inspection is conducted, and the lender is satisfied that all terms and conditions have been met. This usually involves a final appraisal and the execution of new loan documents for the permanent mortgage. Ensure you understand the terms of this conversion at the outset of the loan.

Understanding the nuances of construction loan closing costs is crucial for a successful building project. By being informed and proactive, you can navigate the process with confidence and avoid unpleasant financial surprises.