Building a house is such an exciting time. You get to pick the options and basically draw up the blueprints alongside the architect. There is nothing that can compare to creating your custom house. The downside to this building method, however, is the financing that is involved. You have to come up with a large amount of money in order to keep the builders doing their job – building your home. Without proper financing, your construction could be stopped in its tracks, leaving you without a finished home to reside. In order to prevent that from occurring, you have two options: a stand-alone construction loan and a construction-to-permanent loan. Both types have their benefits, but the most popular loan by far, is the construction-to-permanent loan.
What is the Construction-to-Permanent Loan?
The construction-to-permanent loan provides you with the funds to build the home as well as the permanent mortgage that takes effect when the house is completed. The first portion of this loan is the construction loan. This is when the funds are released in certain draw periods directly to the contractors working on the home. The entire amount of the loan is not disbursed at once, but rather a strict schedule is followed to ensure that the funds are used appropriately. At the closing for the construction loan, the initial funds are disbursed (unlike a standard home purchase closing when the entire cost of the home is released). These funds are usually what is needed to purchase the materials and get the home started. As the process continues, more funds are disbursed as are deemed necessary by the lender and as are agreed by the contractors before the closing. At this time, you are only responsible for paying interest on the amount of the funds that have been disbursed – not on the total amount of the loan. This means that your monthly payment will vary, depending on the amount of funds that were disbursed up to that point.
Once the home is completed and has passed the lender’s inspection, the permanent loan takes over. The loan is automatically rolled over – you do not have to attend another closing and/or pay more fees. You are now in the permanent portion of this loan, which means you are paying different terms; this most likely means that you are paying principal and interest that is fully amortized over the entire term of the loan. The interest rate that you pay on the permanent loan is the one that was locked in when you initiated the process and closed on the construction/permanent loan.
What is a Stand-alone Construction Loan?
A stand-alone construction loan, as the name suggests, stands on its own. At this point, you are only applying for the construction portion of the process – you do not have permanent financing. This means that you have funds to have the home built, but you do not the financing to live in the home for the remainder of the term. The construction loan will likely have a very short-term repayment period as most construction loans are balloon mortgages. This means that the entire amount of the loan will become due in a short period of time – typically when the building is complete. This means that once the home is built, you will owe the full amount of the home. For example, you built a $405,000 home. At the completion of construction, that $405,000 will be due to the lender. Since you more than likely don’t have that kind of cash lying around, you will need permanent financing. Since you obtained a stand-alone loan, you will have to apply for the permanent financing all over again. This means going through the approval process again as well as the closing process. It also means paying more fees as you have to do the entire mortgage process from beginning to end.
What’s the Difference?
Many people wonder what the difference is between taking the construction-to-permanent loan or opting for the stand-alone loan. The largest difference is that you are not guaranteed a permanent loan at the end of the process with the stand-alone loan. You are forced to reapply for a loan. If anything has changed in between the time you obtained the construction financing and the permanent financing, you could have a hard time qualifying. Any difference could change your ability to obtain a loan from a major change in your credit score (a lot can happen in 6 months) to a change in your income which drastically impacts your debt ratio.
In addition to the risk of not qualifying for the permanent financing is the risk that you take with the interest rate. When you obtain construction-to-permanent financing, you are locked into an interest rate right from the start. This means you do not have to worry about your future interest rate when you move into the home, which can be a big relief especially when you are already dealing with the stress of building a home. If you have standalone financing and then have to apply for permanent financing, you are stuck with whatever interest rates are available at the time that you apply for the loan. If you are talking about six or eight months down the road, interest rates will have likely changed. This could be good or bad, depending on the way the market went during that time. Of course, there is no way to predict what will happen ahead of time.
So how do you decide what is right for you? It depends on your exact circumstances. If you want to take the risk on the future interest rate, you can get a stand-alone loan, but you have to be very cognizant of your finances in the meantime. If your income changes (you lose your job or you get hurt and are unable to work) or you have a hiccup on your credit, you could suffer the consequences down the road. If you are not a risk taker, the construction-to-permanent loan is a better choice because it provides you with a little bit of security as you go through the process. It also allows you to pay fewer fees because you only have to attend one closing and go through one loan process, saving you a few thousand dollars in the end.
Justin McHood is America's Mortgage Commentator and has been providing expert mortgage analysis for over 10 years.