3 Minutes on 2 Types of Construction Loans

There are two main types of home construction loans:

Construction-to-Permanent. With these loans, the lender advances the money as needed to pay for construction. After the home is built, the same lender converts the construction loan to a permanent mortgage. There is one loan and one closing for both the construction and the permanent mortgage. This is the most popular option.

Stand-alone construction. With these loans, the lender advances the money to build the house. When construction is finished, a permanent mortgage from the same lender or another lender pays off the construction loan. This is two separate loans and there are two closings.

With a construction-to-permanent loan, there is one closing. At application the lender reviews your financials and the construction plans and qualifies you for a maximum loan amount. During construction, you pay only interest on the outstanding loan balance. Loan disbursements to the builder are made as the work gets completed on the project. The construction loan converts into a permanent mortgage after the home is built. You can lock a mortgage rate at application, even before construction begins.

In some cases a stand-alone construction loan may be more popular if it allows for a smaller down payment. Because this type of loan doesn’t allow a mortgage rate lock in advance, there is a risk of interest rates will rise during the construction period. Another disadvantage is that your circumstances could change during construction, making it difficult or impossible to qualify for a permanent mortgage. And because there are two closings the financing costs will be higher for this option.

Stand-alone construction loans are also used for investments projects whereas the builder intends to sell the new home upon completion. The same lender or another lender may provide a standard permanent mortgage to the new owner.

Qualifying for a construction-to-permanent loan can be more challenging than getting a standard mortgage. Your down payment or equity in the completed property must be at least 20 percent of the loan amount. Also, as part of the loan qualification process the lender will determine whether you can afford the loan payments during construction while you’re paying the rent or mortgage on your current home.

There are almost always unexpected cost overruns when building a new home. You will need additional savings to pay for these unexpected costs. The lender will need to verify these savings to make sure you are prepared to continue with the construction to its completion.

Typically, your lender will also review the builder’s credit standing, financial condition and experience. During construction, the lender will also conduct regular inspections as the home is built. During the construction phase, the lender will disburse payments to the builder in stages called “draws” and send an appraiser or inspector to the building site to make sure the construction is proceeding as planned.

Each Construction to Permanent mortgage is structured to meet the borrower’s specific needs. Building a new home or renovating an existing one is a complex process. A one-time close Construction to Permanent mortgage makes the financing simple. The borrower can focus on their construction project with peace of mind knowing both the construction financing and the mortgage are approved, the rate is set and the details for financing each stage from start to finish has been worked out ahead of time.

ABOUT: Arthur Aranda has over 25 years of mortgage banking experience and works extensively with home builders and homeowners on financing home construction and renovation projects. Aranda is also a Certified Financial Education Instructor and provides First Time Homebuyer Seminars.  For more information on construction loans or to schedule a FTHB seminar please call Arthur Aranda at 201-741-1537.

 

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