How To Choose And Compare Between Construction Loans

Construction financing refers to the structure of financing a borrower uses to build a house.

Buying a completed house is not for everyone.

Many homeowners prefer to have their design inputs brought to fruition and have a house built to as close to their idea of a dream home as possible.

As traditional mortgages are meant for the buying of completed houses or those under the construction of builders and developers, a borrower who wishes to obtain funding to manage the building project himself won’t be able to get a traditional mortgage for his project.

As the individual has no proven record of building houses and the real estate concerned is either an empty plot of land or a soon-to-be demolished house, it makes no sense for a lender to offer a mortgage as there is no certainty as to whether the house will be built at all.

And if the house is built, it might not be of high quality workmanship too.

How do you put a value to that?

This is why construction financing is a more appropriate avenue for borrowers who intend to build their own houses.

There are basically 2 types of construction financing.

  1. One loan
  2. Two loan

I know that can sound ridiculously simple. Let’s look at both in finer detail.

One loan vs two loan

One loan means that the borrower only takes up one construction loan which converts to a permanent loan (mortgage) at a later state when the house is complete.

This is also sometimes referred to as a combination loan.

Two loan refers to taking two loans for the entire works. This include a construction loan for building works. And then a mortgage to repay the construction debt.

This also means that a borrower going to two loan approach would incur closing costs twice.

Construction loans usually run for a period of between 6 to 12 months and carries a variable interest rate that moves with the prime rate. The adjustment interval depends on the terms of the loan, but commonly every month or every quarter.

The interest will of course, only be based on the outstanding balance.

This is partly because the loan is disbursed in stages as it follows a time line of milestones achieved during the construction phase. It would be unfair to the borrower to have to pay interest on the full loan when the facility is only partially used.

Lenders of construction loans also charge a “construction fee” on top of closing costs and points.

Combination loans are often offered by lenders with fee credits.

For example, a lender might credit a portion of fees for the construction loan towards the permanent mortgage. Let’s say 5 points are charged on the construction loan, but 3 of those points will be applied on the permanent loan.

This incentive is to deter borrowers from using another lender for the mortgage.

This credit feature, together with the single closing costs are the biggest advantages of construction financing with one loan.

Yet for the reason of credit rebates, it makes the borrower’s task of comparing between one-loan and two-loan facilities all that more difficult.

For example, if a lender offer a construction loan at 5 points with 3 points applicable on the permanent loan. Another lender offers an untied construction loan at 2 points.

Signing up with the first lender would mean that there will be a saving of 2 points on the construction loan. But that means nothing if the interest rates on the permanent loan are not competitive against those of the second lender.

To avoid confusion, let’s label the first lender as X, second lender as Y, and a third lender as Z.

If X has a permanent loan at 3 points and 5% interest, let’s say a borrower selects just the combination loan offered by X, he would incur a total point cost of 5.

If Z also goes with 5% but 1 point, then a borrower would only incur 3 points if he takes up a construction loan from Y and a permanent loan from Z.

The bottom line would be that while X has the most attractive package for permanent loans, it does not have an attractive construction loan.

They basically even each other out.

Moreover lenders who offer combination loans have done their homework of market research. They know that once a borrower takes it up, the rebate mechanism will single-handedly prevent borrowers from using a different lender for the permanent loan.

This is because as long as the permanent loan is not higher priced than competitors by more than the rebate, a borrower would be crazy to switch.

All these boils down to the complexity (or impossibility) of assessing the attractiveness of a combination loan without comparing it’s permanent loan with the best permanent loan lenders in the market.

When choosing which route of construction financing to go, one should go shopping for construction and permanent loans simultaneously.

Once you get enough data on the current market, if the permanent loan of a combination loan is above the market for an amount that does not exceed the savings on the construction including closing costs, the combination loan is the chosen one.

If not, a two loan alternative would be a better choice.

This leads us to the next dilemma.

If you go with a two loan strategy, you have entered the realm of builder-financed construction.

This basically means that you have an option to have the builder borrower the construction loan instead of you. This would leave you with just the permanent loan as the source of anxiety.

Builder financed construction

While this is obviously a more advantageous position for a borrower, it can present a different set of challenges too.

On the positive side, a developer has the expertise and the financial capacity to take on the project and finish it.

On top of that, a builder with interest costs to worry about will have the motivation to complete the job as quickly as they can.

However, because a builder will undoubtedly factor in the financing costs before quoting the borrower for the job. This will predictably increase the price of the project.

That’s just the beginning.

What’s more uncomfortable to the land owner is that for a builder to obtain construction financing, it needs to have title to the land.

This alone might be too difficult for the owner to accept.

Further more, title switching will just add onto the total closing costs.

For fear of the deal falling through, builders might even make their own decisions on design so as to protect their own interest.

To sum it all up, taking on a construction project is a tough job.

The construction financing part are just events that happen behind the scenes. What’s more important are what happens on site.

Don’t let financing issues compromise the building of your dream home.