A construction loan is a short-term, interim loan provided by a lending institution specifically to construct or renovate a building. The lender makes payments to the builder at periodic intervals as the work progresses. It is a short term financing of real estate construction. Generally followed by the long term financing called a "take out" loan, issued upon completion of improvements. The loan comes due after the construction work is completed. Payments are not made until the balance is due in one lump sum (balloon), usually these payments are Interest only.

Documentation needed prior to loan approval:

• A copy of the signed and dated cost breakdown.
• A copy of the title report.
• A copy of the closing statement from the purchase of the land, or earnest money agreement, if land sale has yet to close.
• A copy of the contract between the builder and buyer.

Types of construction loan:

1. One-Time Close Construction Loan: This type of construction loan will finance the construction of a primary or secondary residence and the permanent loan when construction is finished. A one-time close, also called an "all in one" construction loan, is a fairly simple way to go about building your home. A One Time Close construction loan requires borrowers to sign only one set of documents and allows the borrower to lock in a rate for the permanent loan at this time. This type construction loan will allow for 12 months of construction time and during the construction period interest is charged only on the funds that have been disbursed.

2. Two-Time Close Construction Loan: In this type of loan, there is one closing at the start of construction and a second closing to refinance the construction loan into a permanent mortgage. The costs will be greater for this type of construction loan, but there is a little more flexibility that goes with it. Another thought to take into consideration is that you won't be locked into an end loan amount. A local bank typically provides the construction financing with periodic draws. Monthly interest payments are made to the bank. At completion, a 'take-out' permanent loan is obtained from the bank or a mortgage broker.

3. Note Modification Construction Loan: In this type of loan there are often two separate rates. The first rate covers the construction term (often based on prime), and the second rate is the end loan rate. The construction rate is typically fixed during the construction term, and you'll be asked to pay interest on the amount that is disbursed based on that rate. As construction progresses, your payment will increase accordingly. The end loan rate can either be locked, or left to float with the market. That decision is up to you.