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The excitement of having a home built for you is tempered by the unfamiliarity of the financing. Here are the basics of home construction loans for when you're ready to get a mortgage for building your next home.
2 types of home construction loans
There are two main types of home construction loans:
- Construction-to-permanent: You borrow to pay for construction. When you move in, the lender converts the loan balance into a permanent mortgage. It's two loans in one.
- Stand-alone construction: Your first loan pays for construction. When it's time to move in, you get a mortgage to pay off the construction debt. It's two separate loans.
1. Construction-to-permanent loans
You close the loan only once with a construction-to-permanent loan, which reduces the fees you pay.
During the construction phase, you pay interest only on the outstanding balance. The interest rate is variable during construction, moving up and down with the prime rate. So if the Federal Reserve raises or decreases short-term interest rates while the house is being built, your interest rate will change, too.
The lender converts the construction loan into a permanent mortgage after the contractor finishes building the home. The permanent mortgage is like any other mortgage. You can choose a fixed-rate or an adjustable-rate loan, and specify the loan's term, typically 15 or 30 years. When you're ready, comparison-shop mortgages.
Many lenders allow you to lock a maximum mortgage rate at the beginning, when construction begins. In general, lenders require a down payment of at least 20 percent of the expected amount of the permanent mortgage. Some lenders make exceptions.
2. Stand-alone construction loans
A stand-alone construction loan could be worthwhile if it allows a smaller down payment. That can be a major advantage if you already own a home and you don't have much cash now for a down payment, but you will have more cash after you sell your home. You can live in your current home while your next home is under construction.
This type of loan has drawbacks. For one, you pay for two closings and two sets of fees: First, on the construction loan; second, on the permanent mortgage.
You can't lock a maximum mortgage rate when you get a stand-alone construction loan. If mortgage rates rise during construction, you might have to pay a higher-than-expected interest rate on the permanent loan.
And if your financial circumstances change for the worse during construction, you might find it difficult or impossible to qualify for a mortgage.