If you are considering building a custom home, you’ll want to educate yourself on the options for financing the home of your dreams. Unlike a traditional real estate purchase, a construction project requires unique financing, and as we have discussed in a previous article, you’ll need an experienced construction lender to guide the way. Below, we discuss the 3 types of construction loans most commonly used, and a bonus tip for getting the process started.
Generally speaking, there are three types of home construction loans used for financing a custom home building project. Most lenders require a 20-25% down payment on construction loans and the rates are typically higher than a traditional loan because they are considered a riskier investment for the lender, according to Investopedia.
Lot Loan
A Lot loan is different than a construction loan because it only pays for the land that the construction will take place on. It is also generally a short-term loan, with the assumption that a home will be built on the property in the near future. Some lenders will transfer a Lot loan into a construction loan. The terms of a Lot loan vary by lender with some offering interest-only loans or interest and principal.
Construction/Perm Loan
This type of construction loan is the more common or preferred method for many homeowners. In this scenario, you borrow money to pay for the Lot (if not already owned) and the construction – and there is only one loan closing. One loan closing provides benefits because it often reduces the fees associated with two separate loans. In addition, you are typically able to lock in the long-term rate (or a rate range) for the permanent loan.
During the construction, you pay interest only on the outstanding balance. Typically, the rate is variable during construction and will go up or down based on the prime rate. The lender escrows the funds and releases them after various phases of construction are complete. After construction is complete and a Certificate of Occupancy is obtained, this type of loan is often converted into a permanent mortgage. Some lenders will lock-in a mortgage rate or a range when construction begins. Most lenders require a 20% down payment based on the completed value of the home, but each lender has a variety of loan programs and down payment options, based on what is currently available in the lending market.
Stand-Alone Construction Loan
This type of construction loan establishes a loan for the Lot (if not already owned) and a stand-alone loan for the construction costs. When you are ready to move in, you will receive another loan to pay off any remaining construction debt and to provide a permanent mortgage for your new home. This type of loan may be desirable for those that have an existing home, perhaps with equity, that they want to use as credit towards their down payment. However, this type of loan typically requires two closings, which means two sets of fees – first on the construction loan, and then on the permanent mortgage. Rarely are you able to lock in a rate, so you are subject to whatever the rates are, once the house is completed. In addition, you will need to re-qualify for the second loan so it’s important to understand your options and keep credit and spending in check, during the construction of your home. This can prove challenging to some, so a good lender is the key!
One thing to remember is that with both the Construction/Perm loan and the Stand-Alone Construction loan, the loan amount is determined before construction begins. While allowances may be provided in your construction contract, any variance or additional costs would need to be paid out of pocket. Your experienced lender will be able to answer specific questions about down payment options, draw schedule, rates, fees, and more.
Bonus Tip: Work with an Experienced Construction Lender
The first thing you will want to do is select a lender with extensive construction lending experience. This part of the process may be overlooked but can dramatically impact the overall construction process. Your financial institution should have a good process in place for draws and inspections, to keep your project on-schedule. Use our Questions About Financing Checklist to help facilitate your construction lender selection.
If you are thinking about building your once-in-a-lifetime custom luxury home, be sure to download our FREE ebook: “Designing & Building Your Custom Dream Home: How to Create an Experience You’ll Love to Remember.” Ready to get started? Contact Mueller Homes today, and let’s talk!
