Kahler: Don’t let financing add to the stress of building a home. Your construction loan is probably not a rip-off
Recently I heard from a reader who had just finished building a new home. He noticed something on his loan paperwork that didn’t sit well: his construction loan rate floated 2% above prime.
This was on top of a 1% origination fee and several smaller charges. He questioned why the bank would need another 2%. Wasn’t it already essentially lending out 10 times the money it held, earning easy profits at everyone else’s expense?
His suspicious reaction is understandable. Building a home is a stressful project. Every decision feels consequential, and costs seem to shift overnight. Under that kind of strain, seeing yet another fee can activate a suspicious part that whispers, “You’re being taken advantage of.”
Yet in most cases, construction loan pricing isn’t a sign of greediness. It reflects the fact that a construction loan is both riskier and far more labor‑intensive than a conventional mortgage.
A standard mortgage is secured by a finished home with a clear market value. A construction loan is secured by a plan and a hole in the ground. Weather delays, contractor problems, supply shortages, and cost overruns can derail a build. If something goes wrong, the bank may end up with a partially finished structure that’s difficult to sell and expensive to complete.
Because of this, construction loans require continuous oversight.
Borrowers don’t receive all the funds at once. Money is released in stages, and each draw requires inspections, documentation, lien waivers, and staff time. The origination fee compensates for the upfront work. The extra spread above prime compensates for everything that follows.
The belief that banks lend out $10 for every dollar they hold is also a common misunderstanding. It traces back to the old “fractional reserve” model, which hasn’t shaped bank lending for years. According to the Federal Reserve, reserve requirements were reduced to zero during the pandemic and have remained there.
What does limit lending today is capital. Under Basel III international banking standards, banks must hold a percentage of their own capital against loans. The riskier the loan, the higher the capital requirement. Construction loans sit near the top of that spectrum, meaning banks must tie up more of their own money to issue them.
Banks also pay interest to depositors, borrow from other sources, and maintain costly infrastructures of compliance, cybersecurity, and staffing. Their actual profit is the spread between what they pay for funds and what they earn on loans, known as net interest margin.
According to the FDIC’s Quarterly Banking Profile released on December 5, 2024, the average net interest margin for U.S. banks was about 3%. After expenses, most banks earn returns on equity of roughly 10-12% in stable years. That isn’t an egregious return for a business that wants to maintain stability.
Banks also play a stabilizing role by taking short-term deposits and turning them into long-term loans, a basic but essential function. When that balance slips out of alignment, the consequences can be dire. This was demonstrated by the 2023 failure of Silicon Valley Bank.
None of this makes paying an extra 2% for a construction loan any more appealing. Feeling frustrated about the higher rate makes perfect sense. That does not mean it’s a rip-off. Construction loans aren’t priced to gouge. They’re priced to reflect the real risk, real labor, and real capital they require.
In a perfect world, every new house would go up on time and under budget. In the real world, building a house is complex, uncertain, and deeply emotional. The interest rate premium is part of the cost of turning an empty lot into a home.
Rick Kahler, CFP, is a fee-only financial planner and financial therapist with a nationwide practice, Kahler Financial Group, based in Rapid City. His co-authored books include “Coupleship Inc.” and “The Financial Wisdom of Ebenezer Scrooge.”
The information provided is for educational purposes only and should not be construed as investment advice. The views expressed are subject to change based on market or economic conditions. Past performance is not indicative of future results. Any reference to potential benefits is illustrative and may not apply to your individual circumstances. You should consult with your financial adviser before making any investment decisions. KFG, LLC is an SEC-registered Investment Adviser.
Photo: public domain, wikimedia commons
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