Construction and Bridge Loans Match Special Needs/ November 5th, 2021
Buying or selling a home can be stressful even under ideal circumstances. So, imagine trying to build or purchase a new house while trying to sell your old one. In these circumstances, you may need to turn to special types of financing: a construction loan or a bridge loan. Here are a few pointers for choosing and using these loans wisely.
Borrowing to build
Construction loans work a little differently than most types of loans. Rather than issuing the entire loan amount at once, the lender pays out funds as the construction moves along. For instance, the lender might issue funds after the contractor finishes pouring the foundation, framing the house, and so on through the building process. The lender charges interest on the loan as money is disbursed. The interest rate usually is variable, tied to the prime rate. Typically, the borrower pays only interest, no principal, during the construction period. Borrowers can choose from two types of construction loans:
- Construction-only loan. The borrower pays closing costs for the loan, which usually has a six-month to one-year term. During that term, the borrower pays only interest, and the principal is due in a lump sum at the end of the term. The borrower then applies for a mortgage, which means another closing and an additional set of closing costs. The construction loan and mortgage could be from the same lender, or from different lenders.
- Construction-to-permanent loan. In this case, the lender automatically modifies the construction loan into a mortgage after construction is complete. The borrower deals with just one lender, fills out one loan application, and pays only one set of closing sets. But the borrower also agrees to the mortgage rate and terms before construction is complete. There's no chance to shop around for a new lender after the house is finished.
Which is the better option? "If you do your construction loan and permanent mortgage with one closing, you'll almost always save costs," says Tracy Ashfield, president of Ashfield and Associates, LLC, in Madison, Wis.
Still, those closing cost savings will mean nothing if you end up committed to a permanent mortgage that fails to meet your needs. "If the permanent financing package is attractive to you, great," Ashfield says. "But if it's not, you may be better off doing these two loans as separate transactions." Whichever type of construction loan you get, make sure you have a realistic idea of what your construction expenses will be. Contractors' bids often figure in average allowances for various components—say $10,000 for kitchen cabinetry. But you might be planning to install higher-end products. Make sure your allowances cover what you're looking to put into your home quality-wise. Otherwise, your loan could come up several thousand dollars short. Then you'd either need to refinance or use your own assets to pay off the overrun.
Bridge the gap
Say you're selling your house and buying a new one. But the sale of your existing home won't close in time for you to use those proceeds for a down payment on your new home. This is where a bridge or swing loan comes in.
A bridge loan allows you to purchase a home before you sell your existing home. This allows you to purchase a new home sooner and not risk losing out on an offer to buy.
You could use a bridge loan in one of two ways: Borrow enough to pay off your old mortgage and cover the down payment for your new home. Or leave your existing mortgage in place, while continuing to make monthly mortgage payments, and borrow against the equity in your existing home to pay the down payment for your new house.
A bridge loan is for a short term, say six months. Usually, you make no payments on the loan during that term. You pay off the accrued interest and the outstanding balance on the bridge loan when your old house sells. If, after six months, your house still hasn't sold, you would pay the interest accrued to date. The lender might allow you to renew the loan for six more months, but a bridge loan typically never exceeds a year.
What if that time is up and your house still is unsold? Then you will have to pay the interest that's accumulated and then refinance the note into a loan with fixed monthly payments to cover both principal and interest.
In other words, in a worst-case scenario, you could end up paying two monthly mortgage payments—for your old house and your new house—plus a monthly payment on your bridge loan. That's why bridge loans can be a risky proposition. Ashfield recommends using a bridge loan only if you already have a contract to sell your existing house, and you're just waiting for the closing to get your money. "My personal bias is that bridge loans should be used because of a timing issue," she says. "For instance, maybe you want to close sooner on the mortgage for your new home because your rate lock is running out, and you think rates will go up. But you want to make sure your current home is in a solid transaction, even if it's not yet closed."
Ask at your credit union
If you think a bridge loan or construction loan is right for your circumstances, talk to the professionals at your credit union about your goals and explain what you're trying to do.