How does a construction loan work?
Why is a construction loan cheaper than a regular loan?
What comes after the construction loan?
Financing a property often requires large sums of money. Purchasing a plot of land as well as subsequent development and construction of the house consume considerable amounts.
Hardly anyone can cover the financing of such a project entirely from their own funds. With a construction loan, a large portion of the financing requirement can be covered under favorable conditions.
How does a construction loan work?
The term construction loan also covers designations such as construction mortgage, construction financing or property loan. A construction loan is most often structured as an annuity loan. A structure of interest and principal like a typical installment loan is rarely found.
With an annuity loan, the ratio between interest and principal shifts monthly while the monthly payment remains the same. Interest is charged only on the remaining portion of the outstanding debt. Given the long terms of real estate financing, this is sensible.
As collateral for the construction loan or construction financing, an entry of the granted amount as a land charge (Grundschuld) is made in the land register. This secures the lender against loss.
If the repayment of the construction loan does not take place for any reason, the lender can sell or auction the property. From the proceeds, they may retain their claims together with accrued interest. The remainder is paid out to the former borrower.
In the case of heavily indebted properties in very poor structural condition or in need of extensive renovation, a residual debt may still remain.
When concluding the construction financing, a fixed interest period for the property's financing can also be agreed for several years. The interest fixation guarantees favorable terms for the borrower for a specified period.
To compare a construction loan, many construction loan calculators are offered on the internet in which desired parameters such as the fixed interest period or the term can be entered.
Why is a construction loan cheaper than a regular loan?
Interest rates for construction loans are particularly low compared to the rest of the loan market. They are fundamentally determined by the key interest rate of the European Central Bank, at which the financing bank refinances itself at the start of the construction loan.
The bank adds its profit margin to this key rate as well as an interest component for expected inflation and the assessed default risk. The default risk for the construction loan is low for the bank because of its first-class security provided by the enduring tangible value of the property.
Therefore, the interest rate and thus the total interest charged are lower than for a conventional loan that offers no collateral and is secured only by monthly income.
Finance experts therefore do not speak of debt but of a liability to the bank when it comes to a construction loan. For a "regular" loan or loan that is used for the consumption of time-limited goods, on the other hand, the term debt is used.
What comes after the construction loan?
The granted loan on a property is tied to the construction purpose during the construction period and is disbursed step by step as completion progresses. When the loan amount has been repaid after a number of years, the house fully belongs to the former borrower.
They can then take out a construction loan again, which no longer needs to be purpose-bound. With this money the borrower could then also buy cars or take trips around the world.
In this way, owners of paid-off properties can mobilize financial means very cheaply. They can avoid the more expensive conditions of the consumer credit market and finance their wishes under attractive terms.
The taking out of such a construction loan is then termed by financial institutions as general capital procurement and not for residential purposes.