If you are planning to build your own home this year, you will probably need a new home construction loan. This article will highlight the critical parts of construction loans so that you can make an informed decision on how to finance new home construction loans.
Unless you can pay cash for your home building project, you will need a construction loan to pay for large portions of the labor and materials. A home construction loan also can be used to buy land for your house to sit on, too.
Home construction loans are more complex than a regular mortgage loan; you are borrowing funds for a short time to construct a building that does not exist yet. A construction loan then is basically a line of credit similar to a credit card. But in this case, a bank controls when money is borrowed and paid to your contractor.
A home construction loan requires bank approval for both you and the builder. The bank has to check that you can afford the loan and will have enough money to finish the project. The contractor must show he has the financial ability and skills to get the house constructed on time and under budget.
What Are the Two Types of Home Construction Loans?
There are two types of construction loans: one time close loans, and two time close loans.
In all of these loans, money is distributed by the lender according to a draw schedule that was set up in advance. For example, so much money will be disbursed when the foundation is done, and so much when the framing is done. The idea here is to only pay for work that has been finished, minus holding costs. The latter is typically 10% of the total project amount. This will be held back until everything is finished on the property and it is occupied.
During construction, the payments are interest only. They start out small as you will only pay on the funds that are handed out to the contractor.
When construction is finished, you will make a large balloon payment for all that is owed. On some construction loans, there will be no payments due until the house is finished.
Fees for construction loans are higher than a regular mortgage; the risks are greater for the construction loan lender because the building is not complete. Also, the bank must carefully manage fund disbursement. This takes more work than funding a regular mortgage. See my recent article that highlights the similarities and differences between a construction loan and HELOC.
About One Time Construction Loans
These are the most popular for home buyers. But they can be hard to find in some parts of the US. They are also referred to as construction to permanent loans. These will wrap your construction costs into the mortgage so that you have one loan.
These are good loans if you have a very good idea on what the project is going to cost.
A one-time construction loan has a single approval process and one closing. This makes the project simpler and reduces your closing costs. Within the one time construction loan, there are several different options.
Some lenders may charge a higher rate for the construction loan than permanent mortgage financing. The borrower can usually select from several mortgages, such as a 30 year fixed loan, FHA construction loan, or several ARMs.
Some banks may allow you to lock in a fixed rate loan with a float down variable. This would let you get the lower rate if rates fall. This costs you of course. If the construction takes more than a year, you may have to pay more.
Here are some considerations for one time close loans:
- You pay only one set of closing costs.
- You get approved for both the construction and mortgage at the same time
- Permanent financing has several options
- FHA Construction Loan with 203K
- If you go over budget, you might need to take out another loan and pay closing costs again.
- Permanent rates may be higher than with a two time close loan.
About Two Time Close Home Construction Loans
This type of loan is really two loans. You get a short term loan for construction, and another loan for the long term mortgage when the project is done. So, you are refinancing the building when it is done. You will need to get approval and pay closing costs again when it is done.
During construction, you only have to pay interest on the funds that are disbursed. The payments are small at first but will rise with time.
The bank usually will add a contingency fee of up to 10% on the loan in case costs go over. This happens often with home construction. It is always best to qualify for as much money as you can. That way, you have a cash reserve to tap if you need it.
You have two loan settlements with a two time close loan, so closing costs are higher. But you often can get a better interest rate on your permanent mortgage.
Considerations for this Type of Construction Loan:
- More flexibility to modify your plans and boost loan amount.
- Mortgage rates may be lower than the one time close loans.
- You can shop around for a permanent mortgage.
- You have to be approved two times.
- You face financial risk if your circumstances changed before you apply for a permanent mortgage
- If you do not get approved for your mortgage, you could be foreclosed up.
The Bottom Line
Both types of construction loans can work well for your construction project. Which one is best for you will depend upon your personal finances and the type of project. Getting a one close loan is often less risky, and is the type of loan we see more often.