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Construction loan is a short term loan that is used to finance the construction of a new home. During the term of the loan the lender makes payments to the builder as the work progresses and the borrower makes interest payments on only the funds that have been disbursed to the builder. Typically, the construction loan is refinanced into a permanent loan after the home is completed.
Construction can be financed in two ways:
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One way is to use two loans, a construction loan for the period of construction, followed by a permanent loan from another lender, which pays off the construction loan. Two loans mean that you shop twice and incur two sets of closing costs.
- The second way is to use a single combination loan, where the construction loan becomes permanent at the end of the construction period. One loan means that you shop only once but you must shop construction loans and permanent loans at the same time. The single loan approach results in only one set of closing costs.
Types Of Construction Loan:
1. One-Time Close Construction Loan: A one-time close, also called an "all in one" construction loan, is a fairly simple way to go about building your home. This type of loan offers a single close, and a single rate for both the construction term and the end financing (we'll touch on the rate later). Typically, these loans allow for a maximum 12 month construction term, and may have penalties for going over. Once the loan is settled construction may begin. You'll be asked to pay either interest on the money that has been disbursed to the builder, or a regular mortgage payment. This varies from lender to lender so be sure and ask what your options are before you get to far along. The funds are released either by a draw schedule, or a generic punch list. As your home nears completion, you'll need to consider your final rate. At the settlement, you may have been given the options to either lock or float your rate. If your rate has been locked, you may have the ability to float down for a cost, typically one percentage point of the loan amount. If you chose to float your rate, you'll need to contact the bank about agreeing on and securing the final note rate. Once your rate is decided upon, and your home is completed, your note will automatically convert to a 29 year mortgage. The loan will be 29 years because one year was used during the construction period.
2. Two-Time Close Construction Loan: This loan is just as it sounds, there is one closing at the start of construction and a second closing to refinance the construction loan into a permanent mortgage. Upon closing on your construction loan you'll begin making interest only payments to the lender, and just as before these payments will increase as construction progresses. Once your home is completed, you'll need to refinance your construction loan into a permanent mortgage. The costs will be greater for this type of construction loan, but there is a little more flexibility that goes with it. Generally, you'll be able to get a lower rate on your permanent mortgage because you'll be working with a true refinance rate, not the rate based on a construction to perm loan. Another thought to take into consideration is that you won't be locked into an end loan amount. This is important to consider in case you have any cost over runs or upgrades.
3. Note Modification Construction Loan:
This loan looks a lot like the one time close construction loan, but with a few unique features. The first difference to address is that there are often two separate rates. The first rate covers the construction term (often based on prime), and the second rate is the end loan rate. The construction rate is typically fixed during the construction term, and you'll be asked to pay interest on the amount that is disbursed based on that rate. As construction progresses, your payment will increase accordingly. The end loan rate can either be locked, or left to float with the market. That decision is up to you.
You'll be paying interest on the money that is disbursed throughout the construction term until your house is complete. Once your house is complete, it is time to modify your construction loan. Modification is simply the process of converting your construction loan into a permanent mortgage. While there may be costs associated with this, they won't be nearly as much as a second settlement. Typically, the costs that are incurred during modification are to establish your escrow accounts and pay for any outstanding interest or other fees that may have accumulated during construction.
Whether you chose a one close, a one close with a modification, or a two close, make sure that you have all of your bases covered and plan for surprises.
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