mortgage

Options to finance construction of a new home

Don TaylorDear Dr. Don,
We are planning to look for financing to build a new home. At the same time, we aren't planning to sell our current home in the near term. We own our current home free and clear. Which makes the most sense for financing the new construction: a home equity line of credit on our current home or a construction-to-permanent loan?

Thanks,
-- Margaret Mansion

Dear Margaret,
It's a tough call. In arriving at your decision, the goal should be to minimize total interest expense arising from your financing. Fortunately, if you decide to obtain a home equity line of credit, you do have equity in your residence.

You didn't explain how you'd establish equity in the new home. A conventional mortgage requires 20 percent equity in the home to avoid private mortgage insurance, also known as PMI. The equity can be achieved through the difference between construction costs and appraised value, your investment in the land or bringing cash to closing.

Construction-to-permanent financing requires only one closing and one set of closing costs. The potential downside here involves how the interest rate is determined when you transition to permanent financing.

If construction takes longer than the rate lock (when and if available) on the construction-to-permanent financing, then you're taking on the interest rate risk through construction. If taking this route, you become a captive consumer on financing costs.

Worker building staircase © mihalec/Shutterstock.com

A third option is to separate the construction loan from the permanent financing. This can give you more flexibility to find the least expensive construction loan and least expensive permanent financing.

You should be able to get the construction loan as an interest-only loan at the prime lending rate, which is currently 3.25 percent. That's well below Bankrate's national average for a home equity line of credit, or HELOC.

At issue is the trade-off between paying two sets of closing costs versus one, and the pricing of the permanent financing. The longer the construction process takes, the more likely you'd be better off doing two separate financings.

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