Financing land to Build a House
Unless you are paying cash for your project, you will need a construction loan to pay for the materials and labor, and you can use it to buy the land as well. Construction loans are a bit more complicated than conventional mortgage loans because you are borrowing money for a short term for a building that doesn’t yet exist. They are essentially a line of credit, like a credit card, but with the bank controlling when money is borrowed and released to the contractor.
Both you and your contractor must be approved for the loan. The bank wants to know that you can afford the loan with enough cash left over to complete the house, and that the contractor has the financial strength and skills to get the house built on time and on budget.
If you are converting the construction loan to a mortgage when the building is completed, the bank also wants to know that the finished building plus land will have a high enough appraised value to support the mortgage. Because the lender needs to know the story behind the project, and believe that you can make it happen, construction loans are sometimes referred to as “story loans.” There are many variations on these types of loans from lender to lender, and they change frequently, so you should talk to a few different lenders to see what plan is best for you.
Construction loans are harder to find than conventional mortgages. Start with your local bank where you already have a relationship. Also speak with other local banks including community banks, credit unions, and cooperative banks that are more likely to make these types of loans.
Owner-builders face additional obstacles since you will need to convince the bank that you have the necessary knowledge and skills to get the job done on time and on budget.
Two types of construction loans. The two basic types of construction loans used by homeowners are one-time-close loans, and two-time-close loans. In all construction loans, money is disbursed by the lender based on a pre-established draw schedule, so much money upon completion of the foundation, so much upon completion of the rough frame, and so on. The goal is to only pay for what has been completed, minus retainage, typically 10% of the cost of the project, which is held back until everything is completed properly and the owner is issued a certificate of occupancy (CO).
During the construction phase, payments are interest-only and start out small as you only pay on funds that have been disbursed. When construction is complete, you pay a large balloon payment for the full amount owed. On some loans, no payments are due until the house is completed. Fees on construction loans are typically higher than on mortgages because the risks are greater and banks need to do more work managing the disbursement of funds as work progresses. The faster the work is completed, the less you will pay in interest.
ONE-TIME-CLOSE CONSTRUCTION LOANS
These are the most popular type of construction loan for consumers, but are now difficult to find in some areas. Also called “all-in-one loans” or “construction-to-permanent loans”, these wrap the construction loan and the mortgage on the completed project into a single loan. These loans are best when you have a clear handle on the design, costs, and schedule as the terms are not easy to modify.
The loan has one approval process, and one closing, simplifying the process and reducing the closing costs. Within this basic structure, there are several variations. Many charge a higher rate for the construction loan than the permanent financing. Typically, the borrower can choose from the portfolio of mortgages offered by the lender such as 30-year-fixed, or various ARM’s (adjustable rate mortgages). Some banks will let you lock in a fixed rate with a “float-down” option allowing you to get a lower rate if rates have fallen, for a fee of course. There may be penalties if the construction phase of the loan exceeds 12 months.
Paying a slightly higher rate on the construction phase of the loan is usually not significant, since the loan is short-term. For example, paying a extra 0.5 percent on a $200, 000 construction loan over six months, would only add no more than $250 to your borrowing costs.
Construction loans are typically interest-only and you will pay only on the money that has been disbursed. So your loan payments grow as progress is made and more money is released. When the home is completed, the total amount borrowed during the construction loan automatically converts to a permanent mortgage. If you locked in a fixed mortgage rate at closing, but rates have since fallen, you can lower your mortgage rate by paying a fee – if your loan has a float-down option, a feature you will probably want on a fixed rate loan. If you had chosen a variable rate, pegged to the prime or another benchmark, then you will have to pay the current rate at the time the mortgage converts.
If interest rates are stable or rising, locking in the rate at closing makes sense. If rates are falling, a floating rate would be better – at least in the short run. If you have no idea which way rates are headed, a locked rate with a float-down provision may be your best bet.
Pros of one-time-close construction loans:
- You pay just one set of closing costs.
- You are approved at the same time for both construction and permanent financing.
- Multiple options for permanent financing give you flexibility.