Construction Financing

Are you dreaming of a new home?  One that you build to your exact specifications?  If so, you will likely need a construction loan, which can seem tricky if you have not encountered one before.

Most people are familiar with home mortgage loans.  You find a home you want to purchase and a bank or mortgage company to lend you the money.  You take title to the property, and the lending institution holds a mortgage as a first lien on the property.  But what if you want to build a home?  Construction loans a more complicated than traditional mortgages because a lender will not advance you the total sum to build a home when there is no collateral to secure the debt.

In order to secure a construction loan, you will need to provide the lender with a construction timetable.  Construction loans are generally for a one year period or less, so the home needs to be built in a timely manner.  Funds will only be released once certain progress levels are verified by the lender.  The release of funds is called a "draw," and lenders will have different procedures for how draws are obtained.  The homeowner and the builder will be required to sign off on the terms of the draws.  In addition, a lender will not release funds until it has received lien waivers from all subcontractors.  

The lender will require lien waivers from subcontractors because a mechanics lien can be superior to a construction loan.  A mechanics lien gives someone who furnishes goods or services to construct or improve real property a lien on that real property by which payment can be enforced.  Mechanics liens in Illinois are governed by the Mechanics Lien Act.  Its provisions are automatically included in every contract regarding improvements to real property.

If the lender paid the general contractor without receiving the lien waivers, a subcontractor or material supplier could appear claiming never to have been paid. Those subcontractors or material suppliers likely have valid mechanics liens against your property, which they can enforce through foreclosure – which means the property is sold to satisfy the debt.  Faced with this situation, a homeowner may pay, again, rather than face such drastic consequences.  Although that homeowner may well have a claim against the general contractor, that claim will likely need to be enforced through litigation.  A lender will want to avoid any disputes of this type.

As the homeowner, however, you should know that the escrow is set up to protect the lender, not you. In other words, a construction loan escrow is no excuse to relax your diligence, and you also want to verify the quality of the work and that all lien waivers are received.  Although a lender will inspect the property to ensure that certain work has been completed before issuing funds, its inspection is not a quality control inspection, and the lender is not reporting on the quality of the work done.  It is up to the homeowner to monitor the quality of the construction, and you may wish to engage a construction manager to do this.

In the past, a construction loan was paid off after construction by means of a second loan, a traditional mortgage.  Now most lenders are offering "construction-to-permanent financing," which requires only one loan closing – which should reduce overall closing costs.

The interest rate on a construction loan may be higher than for a traditional mortgage, as the lender is generally taking a larger risk.  The rate may also be variable.  Generally, the borrower only pays the interest on the loan during the construction phase and does not make payments on principal.  If rates are low at the time you begin building your home, ask your lender about the ability to lock in the rate once your traditional mortgage goes into effect.

The lender will not release the final draw on the loan until a certificate of occupancy has been issued for the property.  A certificate of occupancy is issued by the Sangamon County Department of Public Health Building Safety Division.  A property cannot be occupied, whether for residential or commercial use, until it has received a certificate of occupancy.  Before issuing the certificate, all major systems of the home will receive a final inspection including plumbing, electrical, mechanical.  These systems will have received inspections during the construction process, but at the final inspection everything must be installed correctly and operational.

There are many things to be monitored while building a new home – the construction itself, the operation of your loan, lien waivers, etc., but at the end of the process you can have your new home exactly how you want it to be.