2 types of construction loans explained
It’s exciting to have a house built for you, but the complexity and lack of awareness of mortgage loans for new construction can temper your enthusiasm.
Learn the basics of construction loan and get ready when you decide to build your own home.
2 types of construction loans
There are two main types of home building loans:
- Permanent Construction: You borrow to pay for the construction. When you move in, the lender converts the loan balance into a permanent mortgage. It’s two loans in one.
- Self Build: Your first loan pays for construction. When you move in, you take out a mortgage loan to pay off the construction debt. These are two separate loans.
Loans from construction to permanent
You only have one fence with a permanent construction loan, which reduces the fees you pay.
During the construction phase, you only pay interest on the outstanding balance. The interest rate is variable during construction, increasing or decreasing with the prime rate. If the Federal Reserve raises or lowers short-term interest rates during the construction of the house, your interest rate will change.
The lender converts the construction loan into a permanent mortgage once the contractor has completed the construction of the house. The permanent mortgage is like any other mortgage. You can choose a fixed or adjustable rate loan and specify the loan term, usually 15 or 30 years. When you’re ready, shop around and compare mortgage rates.
Many lenders let you lock in a maximum mortgage rate at the beginning of construction. Lenders usually require a down payment of at least 20% of the expected amount of the permanent mortgage. Some lenders make exceptions.
Autonomous construction loans
A self-help building loan can work well if it allows you to make a lower down payment. This can be a major benefit if you already own a house and do not have much money for a down payment, but you will have more after the sale of your home. You can live in your current home while your next house is under construction.
This type of loan, however, has disadvantages:
- You pay two closures and two sets of fees – first on the construction loan; secondly, on the permanent mortgage.
- You can not lock a maximum mortgage rate. If rates rise during construction, you may have to pay a higher interest rate than expected on the permanent loan.
And if your financial situation deteriorates during construction, it may be difficult, if not impossible, to claim a mortgage.
Qualifying for a construction loan is more difficult
When you apply for a loan to build a house, the lender does not have a full house as collateral, so it can be harder to qualify for a loan. The lender will want details about the size of the house, the materials used, and the contractors and subcontractors who do the work. The general contractor can gather all this information.
In addition to this, the lender must know that you can make your monthly loan payments during construction. If the lender thinks you can not make your current rent or mortgage payment while building your house, you will not qualify.
If you’re sure you can qualify, use Bankrate’s Mortgage Comparison Tool.
Adequate savings for unexpected costs a must
The lender will ensure that you have savings to pay for unforeseen costs. “When you build a house, there are always cost overruns that you may not know until you are. We do not want them to use every last penny they have before they start, “said Penny Hance, former director of Eastside at Washington Federal in Seattle.
Cost overruns occur when borrowers change their minds about what they want as construction progresses.
Choose your builder carefully
An important aspect of building your home is choosing the right builder. Find one that has the type of house you want in terms of price, style and size. Examine the builder’s references with the local home builders association and ask for references from previous customers. Check with the Better Business Bureau to see if there are any complaints against the builder.
Typically, your lender will look at the builder’s credit situation, financial situation and permits, as well as the balance sheet of similar home construction.
Expect inspections during construction
Lenders will perform routine inspections as the house is built. During this period, the lender pays the builder in stages, called “draws,” and usually sends an appraiser or inspector to make sure the construction goes as planned.