So you’ve found the ideal property, and you’re ready to get moving on construction. But there’s the issue of financing. Unless you’re sitting on a sizable chunk of investment capital, you’re going to need some help. But here’s the challenge: there are a lot of different construction loan options, and deciding which is right for you isn’t as simple as it should be. Where do you even begin?
What is a Construction Loan?
Typically, a construction loan is short-term financing designed to cover the costs of building a new home (or any type of new construction project). They’re available to anyone who is ready to put time and money into property construction and its related expenses, whether it’s a homeowner, a contractor or a small business owner.
Construction loans are a wholly different type of loan than a conventional mortgage because you’re borrowing money for a structure that has yet to be built. This means there’s more risk to the lender, as there is no existing building to be used as collateral. As a result, construction loans are a lot harder to get approved. Even with good credit and a good relationship with your local bank, you may find it difficult —maybe even impossible — to get the financing you need to build the home you want. And if you’re not doing to construction yourself, both you and your contractor will need to receive approval.
The Two Types of Construction Loans
Broadly speaking, there are two types of construction loans to consider: a loan that closes once and wraps up your construction financing and subsequent mortgage into one loan process (often called a one-time close loan or a construction-to-permanent loan), and a pure construction loan from a traditional or hard money lender that has to be repaid (usually with a separate mortgage) at the end of the construction process (generally called a construction loan or construction mortgage loan).
Both loans processes have their advantages. The right loan for you depends on what you’re planning on doing and your risk/comfort level.
Also knows as a construction-to-permanent loan, this type of loan combines two types of loan into one for an added level of convenience that you can’t get with multiple loans. It’s works like this: during construction, you only pay the interest on the outstanding balance — the interest is an adjustable rate, and your lender determines it based on the prime rate. Once construction has come to an end, the loan automatically converts to a standard mortgage, and you’ll begin paying principal and interest. Advantages include:
One and Done. There’s no such thing as a loan with no paperwork or extra costs. However, this type of loan means you only have to go through the application process once. And because there’s only one closing, there’s only one set of closing costs.
Locking Rates. Because rates can change, a one-time close loan allows you to lock in the rate of your permanent loan before it goes into affect. This allows you to understand your monthly payments well before you have to start making them.
Security. If you have your permanent financing in place before construction even starts, you’re incurring less risk. Let’s say you lost your job during the build … if you didn’t have your mortgage already tied in to your loan, you’d have a hard time finding the financing you need when the construction phase is done
Once you get approval, your lender will release funds based on pre-determined milestones. Known as a draw schedule, the goal of this system is for the lender to only pay for the construction that has been completed — and they’ll have an inspector carefully watching over the construction to make sure everything is done correctly. Your initial payments will be interest-only, and they’ll be small — you’re only paying interest on the money that has been released so far. When construction is completed, the full amount of the loan is due. Advantages include:
Lower Rates. Because mortgages are a lower risk to lenders when compared to construction loans, you can usually get a lower interest rate on the mortgage loan than if you bundled it with a construction loan.
Flexibility. A single loan comes with a prepackaged program with the same lender. When you have a construction loan separate from the subsequent mortgage, you can shop openly on the marketplace for the best deals possible.
Extra Support. Some lenders will actually hold construction and interest reserves so you’re not making payments on your project for the first 6 months. We offer this at Walnut Street so you can focus on getting your project well under way before having to worry about monthly payments.
What’s Right for You is What Feels Right for You
As with all major financial decisions, the choice is yours in the end. One-time close constructions loans and multiple construction loans both have their advantages. As always, it’s important to weight the pros and cons against each other, and see how they line up with your needs. It’s also important to consider what kind of lender you want to work with and how many hoops you want to jump through. If you need funding quickly and want a lender that can not just help finance an investment, but also help guide your project from start to finish, consider looking beyond the traditional bank.