Construction loans work by providing short-term financing for a building project, allowing the construction phase to be completed so the property owner can use the building as collateral for a long-term mortgage. These type of loans are typically offered at higher interest rates, according to the Consumer Financial Protection Bureau.
Traditional mortgages offer property financing at lower interest rates over as long as 30 years because the risk is guaranteed by a security interest in the property. If the owner doesn't pay, the lender can typically seize the property and sell it to recoup all or part of the loan money. When an owner wants to build a new building on unimproved land or rehabilitate an uninhabitable building, a traditional mortgage is not an option because lenders are often unwilling to assume the risk that a habitable building they can sell to recoup losses on a bad loan may never be completed, explains the Wall Street Journal.
A construction loan is a bridge loan that pays for the construction phase of a building project, notes the Consumer Financial Protection Bureau. The loan is typically provided in a series of advances as construction progresses and meets goals, and the borrower often starts repaying the loan six to 24 months after the initial loan payment is made. Once construction is complete, the owner typically refinances the high-interest construction loan with a long-term loan at a lower interest rate.