Rick Kahler’s Personal Finance Weekly Column
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 two percent above prime. This was on top of a one percent origination fee and several smaller charges. He questioned why the bank would need another two percent. Wasn’t it already essentially lending out ten 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 ten dollars 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 three percent. After expenses, most banks earn returns on equity of roughly 10 to 12 percent 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 two percent 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.
The views and opinions of this article may not reflect the views of The Rapid City Post, it’s affiliates, or advertisers.
