This isn’t the most exciting topic BUT a construction loan is something you NEED to know about when building a house … unless you have enough disposable income sitting around to pay for your new build!
Ok, so for the rest of us… it’s important to know how to finance your home build! By the end of this post you will understand the basics of the two main construction loan options (construction-to-permanent loan vs. stand-alone construction loan) as well as the pros and cons of both.
This is merely an overview of the two main loan types. For detailed info, please see a qualified lender!
HOW TO FINANCE YOUR HOME BUILD: WHAT IS A CONSTRUCTION LOAN?
Well, this is pretty obvious … a construction loan is a loan to construct your home! It is essentially a line of credit that you tap into while constructing your home. Below are some notable points:
- Construction loans are interest-only, AND you only pay on money that is actually disbursed. Your payments start out small and grow as more construction is completed and, consequently, more money is disbursed.
- Your lender disburses the money based on a pre-established draw schedule.
- Construction loans are more difficult to get than permanent financing because you are borrowing money for a building that doesn’t exist yet (ie, the bank has minimal collateral).
- When your home is completed, you pay off the construction loan with permanent financing (i.e. your mortgage).
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Also referred to as One-Time-Close Construction Loan, the Construction-to-Permanent Loan is the more popular option. With this option, you basically have two loans rolled into one.
This is a GOOD thing because you have only ONE approval process, ONE closing, and ONE set of closing fees!
The money borrowed to pay for construction automatically converts to a permanent mortgage once the build is complete. At this point in time, you are able to choose how you want to permanently finance (i.e. fixed vs. variable rate, 15 vs. 30 years, etc).
During construction, the interest rate is variable and moves up and down based on the prime rate. However, you can lock into a fixed rate for the permanent portion. Some banks will even let you lock into a rate before construction begins (for a fee, of course!)
- ONE approval process
- ONE closing
- ONE set of closing fees
- Less competitive permanent financing rates than the stand-alone construction loan
- Less flexibility to go over in budget because locked into certain financing amount
STAND-ALONE CONSTRUCTION LOAN
Also referred to as Two-Time-Close Construction Loan, the Stand-Alone Construction Loan requires a second (permanent) loan to pay off construction debt when your home is complete.
This type of loan is unattractive to consumers for several reasons. The biggest drawback is that you have to go through the approval process AGAIN for a mortgage … which means a second closing and second set of closing fees.
It’s also difficult to qualify for a stand-alone construction loan because your lender has minimal collateral, so the rules are pretty strict!
Not only is this risky business for a lender, it’s risky for you as the home owner too! You don’t get to lock in a permanent mortgage rate prior to construction so you are at the mercy of the prime rate which can move up during building.
You’re also at risk of your financial situation changing before construction is completed … and this could pose a problem in securing permanent financing.
- More competitive mortgage rates because able to shop around
- Greater flexibility to modify construction plans and increase loan during build
- Must be approved twice and pay closing costs twice
- Risk of increased interest rates before you secure permanent financing
- Risk of your financial situation changing during construction
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Wow, we just covered A LOT of important (boring) info here!
The most popular option is the Construction-to-Permanent Loan because you only go through ONE approval process and ONE closing … plus you can lock in your permanent rate.
The other option, Stand-Alone Construction Loan, does offer some benefits (flexibility in permanent financing), but the risks are higher, so you should strongly consider the pros and cons.
I hope you now better understand how to finance your home build and feel more confident in making the best decision for your family, budget, and needs!
If you want to dive deeper into planning for your build, download my *FREE* Custom Home Build Prep Guide and learn the 5 crucial steps to prepare for a home build with less stress, more confidence, and without blowing your budget!