Many find construction loan financing confusing. This is because there are two loans required in order to build a home. Both a construction loan and a mortgage loan will be necessary. We will compare the two loans in order to understand how they are different, and interdependent on each other.
Construction Loan Financing: Construction Loan
• The construction loan is a very short term loan. In six to twelve months, when the home is complete, it will be due in full. That’s why you need a mortgage loan.
• The funds of the construction loan are placed in an escrow account, which only the home builder has access to. If you act as your own general contractor that means you, but if you hire a home builder or contractor then their company has access to the money.
• The funds of the construction loan will be withdrawn on a pre-determined draw schedule, based on the projected timetable for construction.
• Funds are taken out only as needed. If any money is left over it is returned to the bank, and the balance subtracted from what you owe.
• Home buyers pay interest only payments that can, according to the terms of the loan, possibly be deferred and added to the balance of the loan.
• There is no method of repayment involved in a construction loan. It is a balloon note, due on the completion of the loan.
• A home building loan has only one singular purpose, to finance the construction of the house. Funds from this loan cannot be used for any other purpose.
• Even if the loan is in your name, you do not have access to the money to do with as you please nor does your contractor, because of the nature of the escrow account.
• The interest rate on the construction loan is much less important than the rate on the mortgage loan.
• Construction loan rates are usually variable, which means they go up and down with the interest rate.
Construction Loan Financing: Mortgage Loan
• A mortgage loan is a long term loan. Mortgage loans are usually for periods of either 15 or 30 years, though it is possible to obtain a 10 or 20 year mortgage.
• The mortgage loan is used to pay back the construction loan. The mortgage loan funds are used to pay off the construction loan in full, and then the construction loan is closed out and ended.
• A mortgage loan is an amortization loan. That means that it is designed to be paid back.
• Each monthly mortgage payment includes some interest and some principle, yet each payment is equal.
• The first payments will be mostly interest, but as the principle is paid down a bit, the interest gradually becomes less, and more is paid toward the principle.
• Making extra payments on a mortgage loans, means that money is applied directly to the principle.
• Extra payment made near the beginning of a loan can take years off the term of your mortgage.
Construction Loan Financing: Interest Rates
• Interest rates are usually lower for shorter term loans.
• Interest rates are currently at an all time low, and can’t get much lower.
• Interest rates are being held down artificially by the FED.
• Historically the highest interest rates were from 15 to 20 percent back in the 1980s.
• It is a good idea to lock in low interest rates as soon as possible, because they can go up.
• Interest rates are lower for people who have good credit. The better your credit, the lower your interest rate will be.
Construction Loan Financing: Options and Alternatives
• It is possible to get a combination loan which acts as a construction loan and then becomes a construction loan. The main advantage is one set of closing costs.
• It is also possible to close both loans at one time, even though they are separate to save on closing costs.
• If your building costs are relatively low, in comparison to your income and savings, it is possible to get a personal loan on your signature for the purpose of construction.
• It is also possible to get a loan using something other than your home as collateral. The advantage to this, if you have something else of equal value, is that your home is not at risk in the event of foreclosure.
• Getting a personal loan, or using something else as collateral is useful if you are building a structure that your bank is not comfortable loaning money on, for example alternative materials, or if you are going to build the home yourself and lack experience, which can make the bank very skeptical.
• The shorter the term of the loan, the less interest you end up paying.
There are many assumptions these days in getting a loan. Many people assume that they have to take out a 30 year mortgage on their new home. Some people even assume that since they can borrow a certain amount based on their income, they should borrow the full amount to build a home. Neither of these ideas are sound business thinking. If you can build an adequate home for less, then of course you should. If you can pay that home off in 15 years instead of 30, then you are much better off to do so. If you do not want to put up your home as collateral, there may be other solutions which would be safer. There is no reason to follow the usual pattern in obtaining financing. For more information on construction and financing, download our 98 page book and see other articles on this site about construction loan financing.