A construction loan is based on a future value formula as if the new property were completed. The formula for a construction loan is based on either a percentage of current market value of similar homes, or a percentage of the Cost Value.


  1. Construction-to-Permanent Loan:

    A Construction-to-Permanent Loan is a one-time application with one set of closing costs for essentially two loans. You sign one set of loan documents that covers both the interim construction phase and the permanent loan phase. With this single loan, you can purchase the land or house and complete the construction of your home. When construction is complete, the loan automatically converts into a permanent mortgage on new terms without another application or additional closing fees. You may choose from a variety of permanent loan products up front or at the time of conversion. You are not obligated to take the permanent loan from the construction lender. You should contact your lender to explore all permanent options available in the marketplace 30 - 60 days prior to the completion of your project.

  2. Land Loan:

    This is a good way to finance the purchase of a residential lot for future construction of your dream home. A convenient balloon option usually allows 2 - 5 years to design your home and choose a building professional. When you are ready to build, your lender can arrange the next step, a Construction-to-Permanent Loan.

  3. Remodel Loan:

    Generally if you want to remodel your home, you have 3 possible strategies:

    • Refinance your existing First Deed of Trust loan with "cash out" for remodeling if there is enough equity in the property and you intend to carry the increased balance long term.
    • A Construction Remodel Second Deed of Trust calculates the loan amount by using the future value of the planned improvements. This option should be used when the current property value does not support the loan amount you wish to borrow. These programs usually allow the flexibility of a 30-year mortgage and a 15-year balloon or a fully amortizing 15-year mortgage.
    • Explore a Equity Line Second Deed of Trust if the First Deed of Trust cannot be refinanced cost effectively and when you intend to carry the new loan short term, or less than 5 years.

  4. Second Mortgage/Bridge Loan:

    A Second Mortgage, or Bridge Loan, allows you to take advantage of the equity in your current owner-occupied residence, if it is intended to be sold. The Second Mortgage/Bridge Loan is used to meet your down payment requirements on a Construction-to-Permanent Loan. During construction, payments are usually only made on the interest that accrues. This lets you live in your existing home while you are building your dream home. Your Second Mortgage/Bridge Loan is usually not due until your new home is finished or until you sell your existing home.


The Construction-to-Permanent Loan process is very similar to the process of a standard purchase or refinance. The main difference is that a Construction-to-Permanent Loan involves determining the value of a home that is not yet constructed, whereas a purchase transaction for an existing home does not. To assist the appraiser and lender in determining the future value of the home, the homeowner must provide information on the planned improvements and materials and the total costs to complete the construction.

Construction loans frequently require two appraisals. The lender will compare fair market building costs of your projections and comparable sales to ensure that you are not underestimating costs or over-projecting future value. Some lenders must also evaluate the building professional who will oversee the work to ensure that he or she has the experience and expertise to complete the proposed construction. Once the loan is approved, the lender will simply disburse funds as requested by the borrower and builder, and as updated inspections by the lender verify progress. A lender may also verify with a title company that no additional liens have been recorded against the property. The process is simple and most construction lenders have progress reports available online.


There are a number of costs that go into building a new home. In most cases, you will be required to have a down payment. However, any down payments, equity build-up (if more than 12 months), or soft and hard costs already paid, will usually be credited toward construction equity that the lender requires you to pay. In some cases, the cash or equity that you already have in a project will enable you to get a construction loan with little or no out-of-pocket expenses.

Possible Closing Costs:
  1. Soft costs are permit, engineering, and other costs associated with building the home but not directly part of the actual construction costs. Most construction contracts have the price of these costs figured in. However, if you have paid some of these costs up front, the items may be considered "equity". If you can document the cost with a canceled check or paid receipt, some lenders will credit your costs incurred when they calculate the required down payment on the future property or cost value the new home.
  2. Hard Costs are the actual cost of construction covering all materials and labor associated with the building of the home. Typically, you will enter into a contract with a building professional to build the property. This contract sets forth the work to be done and the costs associated with that work.
  3. Closing Costs are costs associated with the closing of the loan, such as escrow, title, loan fees, inspection fees and appraisals.
  4. Contingency Reserve is a reserve account to cover unforeseen cost overruns in the construction of the home. Usually, 5% of the hard costs will be established in a Contingency Account. Your building professional may require a reserve as well.
  5. Land Value / House Cost: If the property was purchased within the past 12 months, the purchase price of the land or house will be used in determining the site value. If the property has been owned for more than 12 months and is strongly supported by recent and proximate comparable sales, the lender will consider the appraiser's estimate of current value subject to underwriter review. A copy of the closing statement for the purchase of the land must be provided if it was owned less than 12 months.
  6. Loan-to-Value: Most lenders lend based on a loan to value value ratio. Although different lenders will lend higher ratios, generally you can expect to get 80% loan to value. Usually any loan to value over 80% will require a private mortgage insurance, or PMI. If you are requesting the removal of PMI, you will likely have to provide an appraisal. For the purpose of removing PMI, you may request in writing to the current lender that the PMI be removed if the ratio is 80 percent or less.

      Calculating your Loan-to-Value Ratio
    • Start with the purchase price of the property as the value for the property. (We'll use the amount $150,000 as an example.)
    • Subtract the amount of your down payment ($20,000 in our example)
    • Identify your loan amount (the purchase price minus the down payment; in this case $130,000.)
    • Divide loan amount (loan) by the purchase price (value). In our example, this would be $130,000 divided by $150,000, which equals 0.87, or 87 percent - your ratio.
    • Use this number with your lender when referring to your loan. You would say that you want a loan with an 87 percent Loan-to-Value or LTV.
    • In order to get this loan, the borrower would likely be required to obtain PMI.


Construction Loan Application:

The selection of an experienced construction loan expert is your first step in assembling the right team. Your loan application should begin months before breaking ground so your lender can communicate with the architect, contractor, appraisers, underwriters and insurance companies. Your construction term begins on the date you close your construction loan, and you can typically request a startup draw of 5%. Some lenders require that your permits are paid for and approved prior to closing a construction loan. At a minimum, your plans must be complete in order to get the loan approved.


You can obtain home plans from websites, magazines, or by hiring an architect for a custom design. Be sure to interview at least three architects and check all possible references. Your architect is a key part of your team and will be involved in the construction process from start to finish.


You will want an experienced building professional with a reputation for delivering high quality homes on time and on budget. Referrals and reference checks are critical. Once you have made a selection you will want an itemized cost breakdown by trade. Let the contractor know you want contactor fees separate from the material and labor fees. Most will want to charge 20% of the total job. Because materials have such a large range of costs and styles, the key is to create a budget for the initial phases such as plans, permits, foundation, framing, plumbing, electrical. Once you budget for initial phases, you can begin to see how much money you will spend on finishing materials such as kitchen appliances, fixtures, cabinets, doors, flooring, landscaping and so on. Once you have settled on a budget and contractor, you should consult an attorney before signing a contract to ensure your rights and remedies are properly protected.

The contractor's fees are not fixed so the 20% rule is subject to negotiation and an experienced attorney will be able to assist with any negotiation of terms.

Construction Loan Funds:

Disbursements will occur over a period of time based upon the percentage of work completed on the home. Prior to the loan closing, you will designate a construction bank account. Upon receipt of a request, a progress inspection and title search will be conducted. Assuming the inspector, title company, and bank raise no concerns, the money is wired to your account. The initial disbursement at closing includes the payoff of the lot or existing mortgage, if applicable, and related closing costs, less your required equity. As construction progresses, your building professional may submit draw requests with your authorization. As an added convenience, draw requests may be made online, faxed or e-mailed with most lenders.

Construction Time:

Generally construction of a new home should be completed within 12 months.

Part I of this document Buying Your Dream Home
You can also download a Microsoft Word version (52kb) of this document.

Information on this web site is designed to provide general information, not legal or technical advice.

HOME || Attorneys || Services || Client Info || Contact || Terms of Use/Privacy