Understanding The Construction Loan And If It Is Right For You

Understanding The Construction Loan And If It Is Right For You

This post will dive into the difference between obtaining a typical mortgage and a construction loan. While the processes are similar, here is what you will need to provide for a construction loan:

Construction loans typically require construction plans, estimates and detailed cost sheets and a contract from a reputable licensed builder. Each lender will have their own requirements but generally this will be the first.

Speaking of lender, they will need to have expertise in this field since it tends to be more specialized than general mortgages. As such, construction loans can be more difficult to qualify for, particularly when you are paying rent or the mortgage for the home you intend on using the construction loan for. This is because you will have to carry the construction loan at the same time.

So how does a construction loan work?

To sum it up, a construction loan works like a line of credit. You apply and are approved and allotted an amount of money based on the construction that is proposed. The money is released in stages that are dictated by the progress of construction. So that the borrower can draw money from the loan at various stages of completion.

However, the borrower does not get money upfront. The money is only disbursed when work is completed and not for work that will be completed.

Construction loans are a short term solution typically lasting no longer than 12 months. This means that once construction is finished, you will be required to pay off the construction loan. Most people do this by replacing the construction loan with a standard 15 to 30 year mortgage.

There are two types of construction loans.

The single-close construction loan allows you to get both loans, being the construction loan and the long-term loan, at once. Once you complete construction, your loan becomes a traditional mortgage. Lenders may refer to this as getting converted or refinanced. These loans are also referred to as construction-to-permanent loan.

The other type is a two-close construction loan which requires that you get approved for two loans. The construction loan will fund your project, and then once construction is completed, you apply for a permanent loan separately.

Depending on your situation the advantages of a one time closing and multiple closing is detailed below:

For a single close loan, there is one application and one approval. This means you only go through the process once. Which can save a lot of time and headaches as one can get lost in a spiral of never-ending loan research.

One closing could also mean lower cost. Although with costs such as appraisals after construction is completed, it is not guaranteed that a single close would be cheaper. In addition, some lenders allow interest costs associated with the construction loan to be added to the long term loan so there is no payments due during the construction phase. However, as you know, postponing payments could actually have you paying more interest over the life of the loan.

But your risk factor is decrease with a single close loan because you have the security of knowing that your long term financing is in place. Whereas with a two close loan, you would have to reapply once construction is completed and who knows what life circumstances happened between the last time you applied and now. Interest rates could rise, new job, really any number of things that could make applying for a long term loan more expensive or less guaranteed. To this note, with a single close loan – you lock in your rates now, helping you calculate monthly payments and avoiding the risk of rising rates.

With a multiple close loan, rates may be a little better. This is because with a single close, you are lowering your risk which comes at a price in that rates tend to be slightly higher for single close as opposed to two close loans. Also, with a single close loan, your choice may be limited to a 15 year or 30 year loan. Whereas with a two close loan, you are able to go out there in the marketplace and shop for any kind of loan you wish.

I am a first time buyer – is the process more difficult for newbies?

The process is the same for anyone. As with anything else, experience does help. But speaking with your real estate agent and researching loans is your best bet.

What do lenders look for when it comes to credit score and do I have to put anything down?

Construction loans and the long term loans you would need to secure once construction is completed, are typically looked at separately. Being approved for the long term loan first has its benefits so the borrower can know all of their costs upfront and can plan for construction costs curbing any expectations and not getting themselves into trouble.

Construction loans can average between 4-7% interest and usually involve a 1 point (1% of the total loan amount borrowed) fee. This fee exists because it is a short term loan and lenders cannot make any real profit from the interest on a short term loan. Hence the 1 point fee to make up their profit. At this rate, construction loans are not cash cows for lenders. Construction loans exist to maintain home building progress and hopefully lead to a long term loan for the lender.

The average construction loan will lend you up to 75% of the cost of construction, so the borrower will still need to have cash on hand. Which may be difficult if the borrower also is purchasing a home and coming up with the downpayment for purchase.

How does repayment work?

Repayment terms on a construction loan work the same as any loan. Monthly payments on interest or whatever balance is outstanding at end of term. The one time close construction loans roll automatically into an end loan at the completion of construction. Two close construction loans work the same way. The end loan is approved and ready when construction is complete.

Any way you look at it, you will more than likely need to prepare yourself to enter into any construction project ready to be uncomfortable for a while. But the payoff will most likely make up for that discomfort for a long time to come.

Nick Ralph
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