When building a new property, financing the construction can be a significant challenge. A construction loan is a type of loan that provides the necessary funds to finance the construction of a new property. However, like all loans, construction loans come with interest rates. In this blog, we will discuss how to calculate construction loan interest.
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How does construction loan interest work?
The interest-only approach is used to calculate construction loan interest rates, so the borrower only pays the interest during construction. Construction loans are riskier for lenders; hence they have higher interest rates than mortgage loans.
The interest is typically calculated on the outstanding loan and is charged regularly, such as monthly or annually. The lender’s rules and loan terms determine the interest rate; it can be either fixed or variable.
The lender releases payments in phases throughout construction. Each release calculates and charges interest on the outstanding loan balance.
Construction loans are short-term and must be refinanced into a long-term mortgage loan after completion. The borrower will start paying principal and interest at the market rate at this point.
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How to calculate construction loan interest rate
For calculating construction loan interest, you need to know the loan amount, interest rate, and the draw schedule. The draw schedule shows when each building stage will get cash. Each drawing’s loan sum determines interest.
Let’s say you are building a new property with a total construction cost of $500,000. You got a $400,000 construction loan at 5%. Your draw schedule:
- Draw 1: $100,000 for site preparation
- Draw 2: $150,000 for foundation and framing
- Draw 3: $100,000 for rough plumbing and electrical
- Draw 4: $50,000 for exterior work
- Draw 5: $50,000 for interior work
Multiply the loan sum at each draw by the interest rate to determine the construction loan interest.
For example, draw 1’s loan balance is $400,000.
5% of $400,000 is $20,000.
To calculate the construction loan’s total interest, calculate each draw’s interest and add it together.
Before signing any contract:
- Consult with a mortgage expert or financial advisor.
- Shop around and compare offers from different lenders.
- Fully understand the loan’s terms and conditions, including the interest rate, repayment schedule, and early repayment penalties.
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