Welcome back to the Before You Build Podcast! I’m your host, Carrie Barker (a.k.a. Caroline on Design), and today in episode 15, we’re going to talk allll about how to finance your home build with a construction loan.
This episode isn’t the most exciting topic BUT a construction loan is something you really *need* to understand when building a house … unless you have enough disposable income sitting around to pay for your new build! If that’s the case, I’m super happy for you!
For the rest of us, however, it’s important to know how to finance your home build.
By the end of this episode, you’ll have a basic understanding of the two main construction loan options as well as the pros and cons of each.
Disclaimer: This is merely an overview of the two typical loan types. For detailed loan information and current rates, please speak with a qualified lending professional.
HOW TO FINANCE YOUR HOME BUILD: WHAT IS A CONSTRUCTION LOAN?
Before we get into the two construction loan types, let’s first talk about what exactly a construction loan is.
It’s *kinda* obvious, but a construction loan is a financial loan used to construct your new home.
It’s essentially a short-term, high-interest line of credit that you draw from as you build your home and work is completed.
Here are some important things to keep in mind about construction loans …
- Construction loans usually have variable interest rates that move up and down with the prime rate; also, the rates are typically higher than a traditional mortgage rate because this is a risky loan because the lender doesn’t have the collateral of a home like they would with a traditional mortgage
- Construction loans are usually interest-only and you only pay interest on money that is actually disbursed to contractors, so your payments start out small and they grow as more of your home is completed and, consequently, more money is disbursed to pay contractors
- Your lender disburses the money based on a pre-established draw schedule
- Construction loans are more difficult to obtain than permanent financing because you’re borrowing money for a building that doesn’t yet exist (i.e. the bank has minimal collateral)
- When your home is completed, you pay off the construction loan with your permanent financing (i.e. your mortgage) … and this is exactly what we’ll be talking about in this episode … the two options for paying off your construction loan (i.e. your permanent financing)
The first option is the Construction-to-Permanent Loan … which is also referred to as the One-Time-Close Construction Loan.
With this option (which tends to be the more popular type of loan), you basically have two loans rolled into one. Once your home is completed, the bank automatically converts your construction loan balance to a traditional mortgage.
This option is attractive because you only have to go through the approval process ONE time, and you have only ONE closing and ONE set of closing fees. You don’t have to go back and do all of this again (or pay more closing fees) when you’re ready to secure permanent financing.
Plus, you can typically lock in your permanent financing rate up to 18 months in advance. This is very helpful if interest rates rise during construction (which HAS been happening a lot lately).
Obviously, you won’t know the final amount of your home until the end of construction, but you can go ahead and lock in your terms and rate.
Although you technically only have one loan, the terms are different when you’re in the construction phase vs. the post-build phase.
During construction, you only make payments (i.e. ‘draws’) on work that is completed and you are only responsible for paying the interest during construction.
Once your home is completed and your bank modifies your loan to your permanent financing (i.e. traditional mortgage), you begin making the typical payments of both interest and principal for the entire loan amount (as you would with any traditional mortgage).
Although the One-Time-Close Construction Loan is pretty great, there are some downsides to be aware of.
Construction loans are considered pretty risky, so you may be required to make a larger down payment on your future home and you may be required to obtain additional paperwork and documentation.
Also, lenders typically charge higher interest rates for construction loans (especially during construction) because they are taking on risk AND it might be 18 months before they start receiving principal payments since you are only responsible for paying the interest during construction.
Lastly, if your final construction cost exceeds your construction loan amount, you are responsible for paying the difference out-of-pocket.
Again, PLEASE talk to a qualified lender to get the most accurate information about construction loan terms!
CONSTRUCTION-TO-PERMANENT LOAN PROS
What are the pros of the Construction-to-Permanent Loan?
- You only go through the approval process ONE time
- You only have ONE closing
- You only have ONE set of closing fees
- You can lock in your permanent financing terms and rate before construction starts
- Your lender automatically modifies your construction loan into a traditional mortgage
CONSTRUCTION-TO-PERMANENT LOAN CONS
What are the cons of the Construction-to-Permanent Loan?
- Lenders typically charge higher interest rates
- If your construction cost exceeds your construction loan amount, you’re responsible for paying the difference
- You may be required to put down a higher down payment on your future home and you might be required to obtain additional paperwork and/or documentation
STAND-ALONE CONSTRUCTION LOAN
The second option is the Stand-Alone Construction Loan … which is also referred to as the Two-Time-Close Construction Loan.
This option requires that you secure a second (permanent) loan when your home is complete and you’re ready to pay off your construction loan.
The Two-Time Close Construction Loan is similar to the One-Time Close Loan during the construction phase … you only pay interest on work as it is completed. However, the difference is that once construction is complete, you must pay the construction loan in full.
This type of loan is unattractive to consumers for several reasons. The biggest drawback is that you have to go through the approval process a second time to get permanent financing (i.e. mortgage) … which means a second closing and a second set of closing fees.
Also, a stand-alone construction loan can be risky for you as the homeowner because you aren’t able to lock in a permanent mortgage rate prior to construction so you’re at the mercy of the prime rate which can move up during building.
You also run the risk of your financial situation changing before construction is completed … and this could pose a serious problem when it comes to securing your permanent financing (i.e. your traditional mortgage).
STAND-ALONE CONSTRUCTION LOAN PROS
What are the pros of the Stand-Alone Construction Loan?
- More competitive mortgage rates because you’re able to shop around and you’ll have collateral when you ‘shop for’ permanent financing
- You have greater flexibility to modify construction plans and increase your loan during your build because you aren’t locked into the construction loan amount
STAND-ALONE CONSTRUCTION LOAN CONS
What are the cons of the Stand-Alone Construction Loan?
- You must go through the approval process and closing twice
- You have to pay closing costs twice
- You run the risk of increased interest rates before you secure your permanent financing
- You run the risk of your financial situation changing during construction
YOUR NEXT STEPS
There you go … I hope you now have a basic understanding of the two construction loan types.
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 prior to building your home.
The other option, the Stand-Alone Construction Loan, does offer some benefits such as flexibility in permanent financing, but the risks are higher, so you should strongly consider the pros and cons.
As I’ve mentioned, this episode is just a basic overview of the two loan types. PLEASE talk to a qualified lending professional to get the most accurate and up-to-date information!
If you want to dive deeper into planning for the financial side of your home build, I invite you to attend my *FREE* on-demand video training, ‘3 Simple Keys to Build Your Dream Home Within Budget … without sacrificing your must-haves, no matter how big or small your budget’.