By definition a construction home loan is only one of two necessary loans to build a home. You will in fact need two loans, which are interdependent on each other. A construction loan requires a mortgage loan to pay it off. For this reason many loan companies offer a combined package of sorts that contains both a construction loan and a mortgage loan, but they are still two entirely different loans, just put together for your convenience. Another option is to close the two loans at the same time to save on closing costs. The third option is to obtain and close the two loans separately.

What is a Construction Home Loan?

A construction loan is a loan taken out for the specific purpose of building a home. The funds for a construction loan can be used for no other purpose. Loan funds are placed in an escrow account where only your home builder can access them. If you act as your own contractor then the home builder is you. If you go through a professional home building company, then the home building company is the only one who has access to the money. Home building loans cannot be used to help with your personal bills, or buy things not related to the construction of your home. They can only be spent on direct building expenses, such as materials, labor and permits. The term of a construction loan is generally for one year, or until your home is complete, whichever comes first.

How a Construction Home Loan Works

A construction loan is a type of balloon note. A balloon note is a short term loan that has no payment plan, and ends abruptly with the total amount being due at one time. The loan is payable in a single balloon payment, but a construction loan is paid out gradually as needed. The money for your loan is put into an escrow account. Your home builder or contractor must create a draw schedule of when each portion of the money will be taken out of the account. Interest is paid only on the amount of money taken out. As long as funds remain in escrow no interest is due on them. Therefore the interest on money during the first month is very little, and on the last month your interest will be for the full cost of the home. Most construction loans require interest only payments for each month of the construction process. Others just add the interest to the amount of the loan, which must be paid in full at the end of the construction process.

The Importance of Construction Home Loan Terms

Interest rates – Interest rates on a mortgage are very important because of the long term, but the interest rate on your home construction loan is less important because they are only for a short term. Overall the terms of your construction loan are far less important than the terms of your mortgage loan. Adjustable rates are very dangerous on mortgages, but it matters very little on the construction loan, because interest rates are not nearly as likely to change in less than one year, compared to a 30 year term.

Construction Home Loan Interest vs. Mortgage Loan Interest

At most, you will pay 12 monthly interest only payments and probably more like six payments. A 30 year mortgage consists of 360 payments and a 15 year mortgage consists of 180 payments. Mortgage loan payments include both interest and principle, but they are all equal payments. This causes early payments to include much more interest than principle, while later payments gradually include more and more of the principle. While this sounds convenient, it makes the early payments relatively ineffective in paying down the debt. The longer the term of your loan, the more gradual your payment of the principle and the more interest you pay. Interest on a construction loan is fairly incidental, while interest on your mortgage loan is crucial. It is important to consider this when choosing a combined loan. Focus on getting the best mortgage loan.

Construction Home Loan: Down Payment

Probably the most crucial part of a home construction loan is the down payment. Most construction loans require a 30 percent down payment, but some allow a 10 or 20 percent down payment. Down payment is based on the estimated value of your finished home. The reason for such a huge down payment is to reassure the bank that you are sincere about your interest in building a home and able to pay for one. Banks have experimented with lower down payments, but statistics show that the lower the down payment, the more likely they are to get stuck with an unfinished house no one is willing or able to pay for. Still it harms average people, because most people do not have tens of thousands of dollars to put down on a home.

Construction Home Loan: Don’t Risk the Farm

If you own the lot or acreage, the land value can count towards the down payment, but also remember that if you own acreage and put the whole tract up, as your down payment, then you stand to loose the entire farm plus the house if you default. It is better to survey off the lot for your home and keep the rest of the acreage separate, if you don’t want to loose the farm if you default.

Choosing a Construction Home Loan

When choosing a construction home loan, it is a good idea to package that loan with a mortgage loan and consider the terms of the mortgage loan, more than the terms of the construction loan. This does not mean that the construction loan is unimportant. It is very necessary, but think of it this way, six months to a year is nothing compared to 15, 30 or even 40 years of paying a mortgage. Therefore interest rates on your construction home loan are relatively unimportant. Down payment requirements are very important however if you do not have a lot of money saved.

For more information on obtaining a construction home loan, download our 98 page book, and consult our other articles for more information. Use our convenient site search engine to find articles on construction home loans and other topics that interest you.

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