Understanding Construction Loans
Unlike an existing home or manufactured home purchase, there are actually usually two loans involved in building a stick-built home:
- a short term construction loan (usually 9 to 12 month)
- the permanent 30 year mortgage
If you’ve never built a home before, you might find the construction loan to be somewhat confusing. This article is to help you understand some of the differences between a construction loan and a home mortgage.
A “STORY” LOAN
Construction loans are considered to be ‘story’ loans. What this means is that you are in essence purchasing an idea, or a concept. Since the object that the lender is investing their money on is not tangible (i.e. it doesn’t exist yet) they must know the ‘story’ behind your concept and the story must make financial sense to them before they will be willing to loan you the money and make your concept become a reality . So your job (and ours) will be to make the story interesting to the bank.
One of the things that makes the loan make sense to the lender is the high equity of a brand new stick built home. Because the True Built Home building process saves you as the home owner a lot of money, once the house is done, you will typically move into the home with instant equity. This makes the loan make sense to the bank since they know that they can easily recoup their investment no matter what happens.
FINANCING STICK BUILT VS MANUFACTURED HOMES
At this point, it’s worth pointing out one major advantage to building a stick built home over purchasing a manufactured or mobile home: financing is much easier on a stick built home, because the story makes more sense then lending on a manufactured home. In fact, because mobile and manufactured homes do not accumulate the amount of equity that you will find in a stick built home, banks are growing increasingly hesitant to finance them at all and when they do the terms are often not nearly as desirable as a stick-built home. The reason is that, if you default on the loan, the bank has less of a chance of reselling a mobile or manufactured home as they would a stick built home. So the story of a stick-built home makes more sense than the story of a manufactured home
HOW CONSTRUCTION LOANS WORK
A construction loan is basically like a line of credit. Like a credit card, you are approved to spend up to a certain amount of money to build your new home. Construction loans typically require interest-only payments during construction and become due upon completion (meaning that the house has received its certificate of occupancy). The balance due is then rolled over or ‘converted’ into a typical 30 year mortgage.
Construction loans usually have a higher interest rate than the permanent loan will have-often as much as 7-9%. However, the payments will be lower because you are paying interest only and only on whatever amount you have actually charged against the loan.
At the start of construction, your initial payments on the construction loan will likely be low-just the interest payment on the cost of the land. As you begin work to develop the land, such as excavation, utilities, and other site improvements, you take draws against your loan and your balance begins to grow. Then once construction starts, the home builder takes draws against the loan for materials and labor to build the home. As you continue to take out draws against your ‘credit line’ your payments will increase until you reach the end of construction.
It is possible but not desirable to have a construction loan independent of the final permanent 30 year loan. It is much safer for you to have a combined construction to permanent loan. With this type of loan, once the house receives Certificate of Occupancy, the construction loan is automatically converted to a permanent mortgage loan. The advantage of this is that you only have to have one application and one closing, so you only pay closings costs once. This is known as a ‘one step’ construction loan.
If you thought home ownership was out of reach or you needed a large amount of money to buy a home, think again.