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How Construction Loans Are Different From Home Loans

How Construction Loans Are Different From Home Loans

How Construction Loans Are Different From Home Loans
Construction loan is a short-term loan used to pay for the cost of building a home on a plot. (PropTiger.com)

Do you dream of having a house with in-door swimming pools and multi-car garages? Have you ever thought of building a vacation home or adding an extra bedroom to your existing home? Well, you can make that dream come true, as because banks provide short-term credit to cover building costs while the construction is in progress.

What is a construction loan?

It is a short-term loan used to pay for the cost of building a home or for constructing a dwelling unit on a plot or in your existing house. It is given for the period the construction work is in progress. The loan is secured by a mortgage on the property that is being financed. Your lender would at intervals make sure the funding is used for the purpose it is intended to be used.

Who qualifies?

In a construction loan, banks fund something that does not exist yet, and this is why they impose strict qualifying requirements before they sanction it.

The factors based on which banks sanction such loans include:

Your developer: Banks would ensure the person responsible for the construction is duly qualified to carry out the work and the pre-approved layout plan is followed.

You construction plan: The lender requires the detailed sanction plan of the property, along with the details of the materials used in constructing. The details pertaining to materials can range from the kind of tiles used to the type of flooring.

The margin: The down-payment in a construction loan is higher than a normal home loan. This is because the margin depends on the level of construction. If, say, Rs 10,000 is required at the beginning of the construction, the bank might fund only Rs 3,000; the rest has to be arranged by the borrower at that level.

The technical appraisal: Banks have an empanelled person who estimates the value of the land, along with the structure that is built after, say, every three months. The funding for every stage of construction depends on this technical report.

Your credit: The eligibility criteria of good credit history, qualification, income, experience, credit score, type of employment, etc, remain the same as those for standard home loans.

How construction loans work?

After an approval is granted, the bank disburses the amount based on the construction stage. For instance, the amount required at the initial stage of construction is mostly higher than what is required after the structure is built. You will be receiving the money at designated intervals to carry on with the construction work.

The interest rate and tenure

While the tenure of such loans could range from 12 to 15 years, banks generally charge a floating rate of interest on them. Compared to other loans, the “spread” is also higher, since the collateral is subject to a smooth construction process. (Spread is the difference between the interest earned by banks on assets and interest paid by them on liabilities.) Do a research on the interest rates of different banks before you settle down for a financier. Some banks also lend construction loans only as interest; that is, you pay only the interest part on the amount you have borrowed, and not the principal loan balance.

Quick tips

  • The fixed-obligation-to-income ratio (Foir) for applicable to home loans is similar for construction loans, too.  
  • The loan-to-value ratio (LTV) plays an important role in construction loans because it is difficult to ascertain the market value of an under-construction property. This is why many banks offer 30 per cent funding at the beginning of the construction on a plot. The full disbursement happens when 80 level per cent of the construction is complete.
  • It is important to note that the completion certificate at the end of every level of construction, along with an affidavit-cum-undertaking, is to be obtained from the borrower.
Last Updated: Mon Apr 23 2018

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