How does a construction loan work?

As opposed to a home equity loan, which bases the loan amount on the existing value of your home, this type of loan uses the 'after improved' value. It can be a plus for the homeowner who needs more money to fund a home improvement project. The down side is that the loan is doled out to the contractor in payments determined by a bank assigned inspector after a portion of the work has been completed. This basically puts the contractor in the position of funding the project and getting reimbursed by the bank.

As a contractor for over 26 years, I have performed 1 contract under these terms and will never do so again. This type of situation leaves the contractor to bare the weight of the entire project until reimbursed. Unfortunately, in my case, the bank convinced me that we would be reimbursed with 2 days of each inspection. In reality, we never saw a check earlier than 2 weeks after an inspection. Note: M&T Bank

For wealthy contractors, this would not be a problem. But, in the real world, most of us don't make a great deal of money beyond our means and financing a homeowner's remodeling project...especially a large one, isn't possible.

The downside for the homeowner in this case is the repercussions. As I stated, a very prosperous firm would have no difficulty managing a construction loan. But, if your contractor is like most, it will be a great burden and the job performance could fail. If he doesn't have money to buy the proper materials, he might skimp or substitute inferior ones. If he doesn't pay his employees or subcontractors, they may stop work, perform poorly or sue you for the money (and institute a mechanic's lien on your home).

In summary, you can get a bigger loan because it's based on the greater value of your home. But, the only contractors that should assume such a project are ones who have the capital to carry the expenses until they are reimbursed by the bank.