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Understanding Home Construction Loans

The time has finally arrived to build your dream home! Whether it's a tiny ranch or luxurious Craftsman house plan, your dream home will soon be a reality! The first and often most overwhelming step in the home building process is obtaining financing for your project. There are several options available today that will ensure that you find the right financing for your budget. You'll really want to shop around and contact as many lenders as you can to get the most up-to-date information on loan programs and qualifications since loans are constantly changing, particularly home construction loans.


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Home construction loans are typically referred to as "story loans" because the lender will want to know everything behind the construction of your home. That plays a big role in the interest rate and the options for repaying the loan. Home construction loans are less "cut and dry" than a traditional 30-year fixed rate mortgage. In fact, home construction loans will depend on the actual type of financing you want and the type of home you're building. In other words, your lender will want to know the whole "story" behind your loan. Here is some helpful information to help you get started on finding the right home construction loan:

How Home Construction Loans Work

Generally speaking, home construction loans are short term, variable rate loans. They will be priced at a short-term interest rate, which will depend on what's called the "draw schedule." The lender, the home builder/contractor, and the borrower will agree on a schedule for the construction. Traditionally, there are five to ten different stages of construction and the lender will charge interest based on the amount of money that has been "drawn" to date. In most cases, the borrower will have the option to take out a construction loan that will then "automatically convert" to a permanent mortgage when you move into the home - or you can structure it so that there are two separate loans. Some home construction loans can be written so that they include the cost of purchasing the land as well as building the home.

Different Types of Home Construction Loans?

There are generally two different types of home construction loans, and each of them have their benefits. As a borrower, you should understand the different options that you have when it comes to financing your new home. The names of the loans do a good job of saying what they do and how they work, but let's go over them in more detail.

  • One-Time Closing Loans also called a construction-to-permanent loan. The premise behind this type is loan is that it automatically converts to a standard mortgage after all of the home construction is completed. This usually is when you get the "certificate of occupancy" for the home. There are several costs involved in obtaining a one-time closing loan. The benefit is that you will ultimately reduce your closing costs by combining the land, the construction, and the permanent loan all into one closing. You'll also reduce the cost of additional fees for confirming your credit, performing a title search, and recording the mortgage. The only real drawback of a one-time closing loan is that you don't get to shop around for different mortgage rates when the home construction is complete.
  • Construction-Only Loans are just like they sound - they're short-term loans that are just for the construction of the home. These loans usually range from six to 12 months in length. There usually is an upfront fee, which can be 1 to 3 percent above the current prime rate. You only pay the interest during the home construction, but then the entire principal is due at the end of the term of the loan. Once you're ready to move into your new home and get your certificate of occupancy, you'll have to apply for a mortgage loan. You'll have the opportunity to apply for the loan either through the same lender or you can find a new one. With changing interest rates and loan product, you may want to choose this option because you'll have the opportunity to shop around for the best mortgage rate after your home is complete.

Whether you choose a construction-only loan or a one-time closing loan really depends on your personal preference and your particular financial situation. If you're looking for the security and piece of mind of a loan that will ultimately convert into a permanent loan, then you may want to choose a one-time closing loan. However, if you can afford the upfront fees and cost of a construction-only loan, then you'll have additional time in order to "shop around" to find a mortgage when you're ready to move into your dream home.