Financial Resource Center


Constructive Financing: Build With a Construction Loan

by Marcia Weuve / June 14th, 2004

Have you been envisioning the perfect house, but haven't found it? Perhaps it doesn't exist--yet. Why just build castles in the sky when you could build your dream home here and now? Real estate analysts say nearly a quarter of Americans are looking for new homes to build rather than buy. Whether it's a cottage, condo, or castle, financing a building project can be tricky and requires a type of loan that is very different from a traditional mortgage.

What's the story?

Construction mortgages, more commonly referred to as construction loans, are story loans. This means the borrower has to sell the "story" of the planned building to the lender before it will be willing to lend any money. Not every lender offers construction loans, and those that do often vary widely on their terms, rates, and fees. Construction loans usually are meant to be short term and then are replaced by another more permanent loan once a home is built. There are two basic types of construction loans:
  1. Construction-to-permanent loan. The borrower only pays interest during the construction phase of the project. The lender then automatically converts the loan to a mortgage after the home is built. One of the biggest advantages of this type of construction loan is that there is only one application and one closing. Consumers pay just one set of costs for many of the required underwriting steps such as recording the mortgage, conducting a title search on the property, and confirming credit. While this doesn't allow the consumer to shop around for the best deal on permanent financing, many borrowers have peace of mind knowing they have a mortgage commitment. In addition, these loans usually have low or no up-front fees.
    Contact your credit union to find out more about home construction loans.
  2. Construction-only loan. This arrangement requires separate loans for construction and mortgage. First, the borrower applies for and pays closing costs on the loan for the construction. This loan typically has a six-month to one-year term. Only interest is paid during the building stage, and the entire principal amount is due at the end of the term. In addition to the other fees connected with the construction-only loan, borrowers also can expect an up-front service charge ranging from 1% to 2.5% more than the prime rate. Next, the borrower must apply again for the mortgage and pay another set of closing costs. The two loans can come from the same lender or different lenders. The construction-only loan is appealing to some consumers because of the flexibility it offers. The borrower can shop for the very best mortgage available while the home is being built and isn't locked into one (usually higher) interest rate.

Landing the loan

While planning your new home's construction, don't forget about financing the land you plan to build it on. Many people believe they have to pay off their lot before they can obtain a construction loan. However, many construction loans now are structured to include the cost of the land as well as building the house.
Nearly a quarter of Americans look for new homes to build rather than buy.

Different from traditional home loans

Construction loans differ from traditional mortgages in that they don't pay out all at once. Lenders usually give out funds in five to 10 "draws," timed to specific stages of construction, such as:
  • Pouring the foundation
  • Framing the house
  • Installing heating, air conditioning, plumbing, and wiring
  • Installing cabinets, fixtures, and trim
  • Interior painting and other finishing work
The money normally is paid after each job is completed, and not before.

Good lock

No matter what type of construction loan you choose, however, you'll have to keep a close eye on interest rates; you may even have to gamble a little on whether those rates will rise or fall. Some borrowers are able to select a low rate during construction and then switch over to the current mortgage rate when the house is finished. Or, some lenders will allow a borrower to lock in a rate for the life of the loan six, nine, or even 12 months in advance. Typically, this rate will be higher to hedge against rate increases. If rates happen to take a big drop during construction, however, the lender might let the borrower close at a lower rate.
Construction loans usually are meant to be short term and are then replaced by another more permanent loan.
A 90-day lock is common, although experts warn that unexpected construction delays or other complications can push the closing past the lock date, causing the borrower to pay more, especially if rates increase in the meantime. Many lenders will extend the lock period for a few hundred dollars. Another construction loan option that is becoming popular allows the borrower to lock in a current rate on a hybrid adjustable rate mortgage (ARM) for up to a year. A hybrid ARM sets a certain rate for a specified period such as three, five, seven, or 10 years, and then adjusts annually after that time. Credit unions are beginning to offer more home construction loans. "In the past, we had members coming to us for bridge loans," notes Mary Hanneman, director of marketing for UW Credit Union in Madison, Wis. Bridge loans are another type of short-term loan for borrowers who are buying a new house, but haven't yet sold their old home. The old home is used as collateral, and the loan is paid off when that house is sold. But a building boom in and around Madison has caused UW Credit Union to reassess some of its lending services. "Within the last five years, housing has become limited and construction has been off the charts," says Hanneman. "Many of our members are now building homes. We began offering construction loans in order to better meet the needs of our members." Contact your credit union to find out more about home construction loans or read more about mortgages in the "Housing" section of Home & Family Finance Resource Center.
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