If you’re planning on building your own home, you’ll probably need to learn about construction loans to help finance your project. Keith Gumbinger, vice president for mortgage information and research at HSH.com, offers the basics.
What Are Construction Loans?
Construction loans are a form of short-term lending taken out by someone building or significantly renovating a home for their personal use and meant to finance the building of his/her custom residence. They cannot be used to purchase a new build from a builder putting up a development.
The construction loan funds may be used for labor, materials, permits and other costs associated with construction of the new home. Most are interest-only construction loans, meaning that while the house is being built, you pay only the interest on the loan, usually calculated at an adjustable rate typically in the range of 2% or 3% above the prime rate.
How Construction Loans Work
During the home-construction period—typically about 12 months—the bank releases funds from the construction loan to the general contractor in phases as the work on the new home progresses. The homeowner makes interest-only payments during this time. Once construction on the home is complete, the loan must be paid off in full.
There are two types of loans and repayment models…
Construction-only loan
Once the home is complete and a certificate of occupancy is issued, the owner must either pay it off in cash or take out a mortgage to finance the principal.
Construction-to-permanent loans
In this case, the loan automatically converts to a mortgage with that same bank after the house is finished. Typically, these loans are one-time-close construction loans, meaning that there aren’t separate closing costs for the pre-construction and post-construction phases.
Types of Construction Loan Rates
Consumers often wonder about fixed versus adjustable construction loan rates. Most banks offer only adjustable rates, but a few offer fixed rates, especially on construction-to-permanent loans. These typically have slightly higher interest but allow you to lock in a loan rate. Some lenders offer hybrid loans with initial fixed-rate periods followed by adjustable rates. Borrowers should select the permanent mortgage based on their needs—and the vast majority of borrowers select a 30-year fixed-rate mortgage.
Factors That Affect Construction Loan Rates
Requirements for a construction loan can be demanding. Factors that affect construction loan rates and approval include your current income, credit score and debt load…the projected value of the finished home…and the construction loan down payment. Before a bank commits to a loan, it will want to see detailed plans for the project, as well as local approvals for construction.
Once you’re approved in the construction loan process, your lender will disburse the funds to the general contractor in installments corresponding to the phases of the project. Example: Once the foundation is laid, a bank inspector will come to the worksite to confirm that it was done properly before approving disbursement for the next phase, which may be framing the building.
How and when the interest rate is locked in will depend on the type of loan you get (construction-only vs. construction-to-permanent) and whether the rate is fixed or adjustable. A high credit score can help ensure the lowest possible rate. While it’s not possible to know what a future interest rate may be, some lenders offer extended lock-ins available some months before the completion—in some cases, up to a full year—and these can feature “float down” options in the event that market interest rates decline during that time.
When you are shopping for a construction loan: Ask…
- When exactly the permanent rate is locked?
- Whether there’s an extended rate-lock option.
- Whether the construction phase is fixed rate or variable. As the construction phase typically is pretty short term and features payments of interest only, it’s not crucial to try to secure a fixed rate during this time. It’s unusual for short-term interest rates to spike, so consumers should be more concerned about the interest and term of the permanent mortgage.
- What fees are associated with locking early?
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