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Ask Dr. Don

Financing construction of a new home

Dear Dr. Don,
My wife and I recently bought a lot to build a home on about a mile from where we live now. We do not owe anything on the home we live in presently and are debt free from vehicles to credit cards. Our home we live in now is worth about $210,000 and the home we want to build should come in at about that amount also since the lot is paid for already.

We do not have the money to build the new home without either selling our present home first or borrowing the approximately $200,000 for the new home. If we wanted to live in the home we own presently while we are building our new home, what would be the best route to go as far as financing the new home? A home equity type loan against our present home or a separate first mortgage / construction type loan on the new home?

Are construction loans at a higher interest rate than regular mortgages and what are the advantages and disadvantages to construction loans? Are there any other options or considerations you can think of? The lot we bought is valued at between $40,000 and $50,000. If we borrowed $200,000 will we be liable for PMI or will the value of the lot the house is being built on allow us to avoid paying PMI. Thank you,
Harold Homebuilder

Dear Harold,
A construction loan will be an interest-only loan that comes due once you've received the certificate of occupancy on your new home. Construction-to-permanent financing allows you to secure both loans with only one set of closing costs but you give up some negotiating leverage when it comes time to price the interest rate on your new mortgage.

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If you decide on construction to permanent financing, the lender should offer you the ability to buy a rate lock to lock in an interest rate through the expected completion date. The lock should be effective through the worst case scenario for delivery since an expired rate lock won't be of any use at closing.

If your current home is worth $210,000 you may have some difficulty convincing the lender to loan you $200,000 in a home equity line. High loan-to-value (LTV) home equity loans also carry a higher interest rate. Bankrate defines high LTV lines of credit as those that result in an LTV of 90.01 percent or more.

Private mortgage insurance (PMI) is also based on loan to value calculations. An appraisal of your completed new home will determine whether you will need PMI. The value of the land will be included in the appraised value of the home but may not be dollar for dollar what you paid for the lot.

If you think interest rates are headed higher then you're better off with a construction to permanent financing package combined with a rate lock then financing construction with a HELOC and hoping for the best when it comes to financing your new home.

Read Bankrate's Mortgage Rate Trend Index each week to take the pulse of the mortgage market and see what the experts are recommending concerning rate locks.

-- Posted: March 15, 2004

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From construction loan to regular mortgage
Construction or home equity loan?
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