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Home construction loans are complex: Here are the nuts and bolts

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Two people on site of a house being built | Chris Ryan/Getty ImagesChris Ryan/Getty Images

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:

  1. 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.
  2. 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.

Qualifying for a construction loan

When you get a loan to build a home, the lender doesn't have a complete home as collateral during construction, so qualifying for a loan can be more onerous. The lender will want details about the home's size, the materials used and the contractors and subcontractors that do the work. The general contractor can pull all this information together.

On top of that, the lender needs to know that you can make your monthly loan payments during construction. If the lender thinks you can't make your current rent or mortgage payments while your next house is being built, you won't qualify.

If you're confident you can qualify, use Bankrate's mortgage-comparison tool.

Have adequate savings

The lender will make sure you have savings to pay for unexpected costs. "There are always cost overruns when you are building a home that you may not know about until you are into it. We don't want them to use every last dime they have before they start," said Dennice Henshaw, formerly eastside division manager for Washington Federal.

Cost overruns happen when borrowers change their minds about what they want as construction proceeds.

Do your due diligence on the builder

An important aspect of building your home is choosing the right builder. Find one that has built the kind of house you want in terms of price, style and size. Look into the builder's credentials with the local homebuilders association and ask for references from previous clients. You could also see if there are any complaints against the builder with the Better Business Bureau.

Typically, your lender will look into the builder's credit standing, financial situation and licenses, as well as the track record for building similar homes before you get a mortgage.

Ongoing inspections

Lenders will conduct routine inspections as the home is built. During this period, the lender pays the builder in stages -- called "draws" -- and usually sends an appraiser or inspector to make sure that construction proceeds as planned.

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