Construction loan

Key Takeaways

• A construction loan is short-term interim financing for building or development costs, secured by the property being built and replaced by permanent financing once the work is done.
• Construction lenders release money in stages called progress payments or draws, so the borrower pays interest only on the balance drawn so far rather than on the full loan amount.
• In Washington a construction loan is normally secured by a deed of trust, which is subject to the laws relating to mortgages and may be foreclosed by trustee's sale under RCW 61.24.020.
• Washington construction lien priority relates back to the first labor, professional services, or delivery of materials, so a lender that records after work starts can be pushed behind a contractor's lien.

What It Means

A construction loan is short-term interim financing that covers the cost of building or developing a property, and it is secured by that same property. The lender does not hand over the whole amount at closing. It commits to a maximum, then releases money in stages called progress payments or draws as the work reaches agreed milestones such as foundation, framing, and final completion. An inspection usually has to confirm a stage is finished before the next draw funds.

Because the money goes out over time, the borrower pays interest only on the balance drawn so far, not on the full commitment, which holds carrying costs down during the build. The loan has a short life and it is not meant to be repaid out of monthly income over many years. It is meant to be replaced. Once the building is complete, the borrower either refinances into permanent financing or the construction loan converts to permanent financing under a one-time-close arrangement. On the wider map of loan types a Washington broker should know, construction financing sits with the specialty products rather than with everyday purchase loans. The Promissory Note sets the repayment terms, and in Washington the instrument recorded against the land is almost always a Deed Of Trust rather than a mortgage. That recording date carries more weight here than most students expect.

How It Works in Washington

Washington treats the security instrument and the timing of recording as the whole ballgame on a construction deal. RCW 61.24.020 provides that a deed of trust is subject to all laws relating to mortgages on real property and may be foreclosed by trustee's sale, which is why construction lenders here take a deed of trust instead of a mortgage. RCW 60.04.226 then protects the staged funding: except as otherwise provided in RCW 60.04.061 or 60.04.221, a recorded mortgage or deed of trust is prior to encumbrances not recorded before it, to the extent of all sums secured, regardless of when those sums are disbursed or whether the disbursements are obligatory. So a lender that records on day one keeps first position for draw money advanced months later.

The exception is the one that bites. Under RCW 60.04.061 a construction Lien is prior to any lien, mortgage, deed of trust, or other encumbrance that attached to the land after, or was unrecorded at, the commencement of labor or professional services or first delivery of materials or equipment. That is why lenders record before the first shovel moves and why title companies inspect the site. RCW 60.04.031 requires a notice of the right to claim a lien and generally protects only work supplied after the date sixty days before the notice is given, shortened to ten days on a new single-family residence. RCW 60.04.230 requires the prime contractor to post a jobsite notice on projects costing more than $5,000, and that notice identifies the construction lender or the payment bond.

Example

Priya and Sam Whitcomb own a lot in Olympia and hire a builder for a $480,000 home. Their bank approves a $420,000 construction loan and records the deed of trust on April 3. Excavation does not begin until April 10, so the bank's recording predates the commencement of labor and the bank holds first position. The bank funds four draws against inspections: $105,000 at foundation, $126,000 at framing, $105,000 at mechanical rough-in, and $84,000 at completion. When only the first two draws are out, the Whitcombs pay interest on $231,000, not on $420,000. In November the house is finished, and the construction loan is paid off by a $420,000 thirty-year permanent loan. One subcontractor is still unpaid $18,000. Because that subcontractor first delivered materials in June, after the April 3 recording, its lien sits behind the bank's deed of trust, but it still clouds the Whitcombs' title until it is released.

Common Mistakes and Exam Traps

• A construction loan is not permanent financing. It is interim financing that gets paid off or converted when the building is complete.
• Progress payments are not amortized payments. A draw is a disbursement of principal to the borrower, while an amortized payment is money the borrower sends back to the lender.
• Recording first does not automatically win in Washington. Under RCW 60.04.061 a construction lien relates back to the commencement of labor or the first delivery of materials.
• A construction loan covers one property being built. A blanket mortgage covers several parcels at once, which is a different answer even though a developer may use both.