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What are my construction loan options?

We are planning to build a new home on a lot that we recently purchased (100% paid for). What are my mortgage options for a construction loan?

Harry Jensen, Trusted Mortgage Expert with 45+ Years of Experience
, Trusted Mortgage Expert with 45+ Years of Experience

You have two types of mortgage options for a construction loan to build a home. Your first option is a stand-alone construction loan, which is a short-term loan that only covers the construction phase. Construction loans are typically six-to-twelve months in length, depending on your construction schedule and other factors.

Construction loans are usually structured as interest only mortgages, which means your monthly payments are comprised of only interest and no principal. This reduces your mortgage payments and increases your financial flexibility as your property is being built.

Although you are approved for a certain mortgage amount when your construction loan closes, your monthly mortgage payments are based on your outstanding loan balance, which is disbursed over time according to your construction schedule.

So if you are approved for a $350,000 construction loan but only $20,000 in proceeds are disbursed in the first month, your monthly payment is only based on the $20,000 outstanding loan balance rather than entire $350,000 mortgage amount. Calculating your payment using the outstanding mortgage balance reduces your initial monthly payments although your payments increase over time as your construction progresses.

Review How a Construction Loan Works

When your construction is completed and your property is built, you replace the construction loan with a permanent mortgage such as a fixed rate or adjustable rate mortgage (ARM). In some cases the lender that provides the construction loan also provides the permanent mortgage but you are required to re-apply for the new mortgage. If the construction mortgage lender does not provide permanent loans they usually require that you arrange your permanent financing, also known as a “take-out” loan, before your constrictions mortgage closes.

The negative of a construction loan is that it actually requires two loans and two approval processes for both the construction loan and the permanent mortgage. Requiring two loan applications increases your closing costs and requires additional time and effort. If your credit, financial or job situation changes over the course of the construction, then it may be more difficult to qualify for the permanent mortgage or your loan terms may change.

Other potential complications include fluctuations in mortgage rates or a lower-than-expected property value if the construction did not go as planned. All of these factors can make getting the permanent mortgage more challenging or more expense. For example, if mortgage rates increase while your home is being built, the payment on your permanent mortgage may increase and you may qualify for a lower loan amount.

These challenges bring us to your other construction loan option: a construction-to-permanent loan (also known as a C2P loan). A construction-to-permanent loan combines the construction loan and take-out mortgage into a single loan.

Advantages of a C2P loan include only applying for one mortgage instead of two, which saves you money and time. C2P loans also offer the ability to lock-in the terms for your permanent mortgage before construction is completed, which eliminates the risk of a potential mortgage rate increase. This loan feature provides added certainty and peace of mind for borrowers.

Review How a C2P Loan Works

The construction phase of a C2P mortgage works similar to a standard construction loan. During this period you pay interest only based on the outstanding loan balance, which increases over time as your loan proceeds are distributed to finance construction costs. When construction is complete, the lender orders an inspection to make sure that the property was built according to the agreed upon plans.

Assuming the lender is satisfied with the final property inspection, the loan converts into a permanent mortgage based on the loan terms agreed to when the C2P loan closed. In most cases the permanent loan is a fixed rate mortgage or ARM.

Construction-to-permanent (C2P) loans are provided by traditional lenders such as banks, mortgage brokers and credit unions. We recommend that you contact multiple lenders in the table below to learn about program availability and to check your loan terms. Shopping multiple lenders is the best way to save money on your mortgage.

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Another mortgage program to consider is the FHA mortgage program.  An FHA mortgage enables you to buy a home with a down payment as low as 3.5% and applies more flexible borrower qualification requirements including a lower minimum credit score.  You can also use an FHA mortgage as the permanent loan for a C2P loan.

In this scenario, you work with an FHA-approved lender to arrange both the construction loan used to finance the land acquisition and construction costs as well as the permanent FHA mortgage that takes out the construction loan when the building is complete and you are ready to move into the property.

Review our FHA Mortgage Guide

One benefit of using an FHA loan for a construction-to-permanent loan is that FHA mortgage rates tend to be lower than conventional loan rates.  The downside of an FHA mortgage is that you are required to pay an upfront and monthly mortgage insurance premium (MIP) plus the program applies mortgage limits that restrict your loan amount.  The table below shows FHA mortgage rates and closing costs for leading lenders in your area.  We recommend that you contact multiple lenders to determine if they offer FHA C2P loans and to find the best mortgage terms.

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Another financing option to consider is the USDA home loan program which enables you to buy a home located in a designated rural area with no down payment. Unlike many no or low down payment mortgage programs, the USDA program can be used to finance the purchase of land and the construction of a new home. If you use a USDA home loan as a construction loan, you may be required to make a down payment but the program offers attractive mortgage rates and other borrower benefits.

Review our USDA Home Loan Guide

The negatives of a USDA home loan include applicant income limits and tougher qualification requirements. Plus, borrowers are required to pay upfront and ongoing USDA mortgage insurance fees (also known as guarantee fees).

Use ourUSDA HOME LOAN QUALIFICATION CALCULATORto determine what size USDA mortgage you can afford

You can also use the FREEandCLEAR Lender Directory to search by lender type and mortgage program.  For example, you can search for lenders in your state that offer construction, C2P, FHA and USDA home loans.

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Sources

Construction Loan Guidelines: https://www.fanniemae.com/singlefamily/construction

Construction-to-Permanent (C2P) Loan Guidelines: http://www.freddiemac.com/learn/pdfs/uw/construction.pdf

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About the author

Harry Jensen, Mortgage Expert

Harry is the co-founder of FREEandCLEAR. He is a mortgage expert with over 45 years of industry experience. Over his career, Harry has closed thousands of loans for satisfied borrowers and now offers his advice and insights on FREEandCLEAR.  Harry is a licensed mortgage professional (NMLS #236752). More about Harry

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