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Opinion: Knowing differences between construction loans, mortgages

Industry Insight

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When it comes to obtaining financing for a home, some people may have a general understanding of how home mortgages work. If not, they can always call any local bank or lender to obtain information on how to become approved for a home loan. Most are more than happy to walk you through it.

However, home construction loans are different and can be a little confusing, so here’s some help.

One of the most important steps to securing a construction loan is to ensure you are pre-approved for what’s called the end loan, a mortgage loan that’s established so that when construction is finished, the buyer has a permanent and/or fixed-rate home loan to pay it off.

Now let’s separate construction loans from what most people call a home loan, or end loan as stated above. A home loan is a mortgage on an existing home that is generally paid in periods of 15 or 30 years and features a fixed interest rate. The principal and interest payments are the same for the life of the loan.

These home loans – known as mortgages – can be obtained through most banks, mortgage companies, mortgage brokers or credit unions.

These conforming or secondary market loans are where the lender will look at Fannie Mae or Freddie Mac for conventional financing, with loan amounts as high as $453,100, or through government agencies like those run by the Federal Housing Administration for loan amounts as high as $294,515, Veteran Administration loans for amounts as high as $453,100 with zero down payment possibilities, or Rural Development loans through the United States Department of Agriculture.

In contrast, a construction loan is underwritten to the bank or lending institution’s standards and lasts for only the length of time it takes to construct the home, which can range from four to 12 months depending on the size and scope of the home. Some larger homes can take longer than 12 months to build and you are essentially given a line of credit up to a specified limit.

As the home is built, the builder, through the title company, will submit draw requests to only pay for the work that has been done and you pay interest on what you have borrowed as you go.

For example, if you have a $350,000 construction loan, you won’t have to start paying anything on it until your builder submits a draw request  – perhaps something like $20,000 to start – and then you’ll only pay the interest on the current balance, in this case the $20,000 that has been drawn.

The best way to think about a construction loan is like having a credit card for building your home. You only pay on what they owe on the card – in this case, what you pay on the construction loan. As more is drawn on the loan as needed to move construction along and the balance grows over time, payments will increase, as well.

This process will continue until the house is complete and all costs have been included in the construction loan. At this point, you will obtain a mortgage for the house you’ve built, which will pay off the balance of your construction loan.

Once again, it is important to point out that the borrower should be pre-approved for the mortgage loan prior to starting a construction loan. There should be no pre-payment penalties with a construction loan, so you can pay off the balance whenever you like, either when it comes due or before. In some aspects, when the construction loan is fully drawn it becomes like a balloon note, where the balance is due at the time of maturity. Once again, here is where the mortgage loan, the end loan, will be put in place to pay off the construction loan.

Interest rates on the construction loans are set by the bank or lending institution based on many different factors. For instance, your loan-to-value ratio will be determined based upon the value of your property. Usually it’s 80 percent or less for construction loans, meaning your loan will be 80 percent or less of what the appraiser says the house will be worth when finished.

Credit scores, income, assets and other factors might be taken into consideration by the bank or lending institution to determine the interest rate for the construction loan. This will be different than what you would be looking at for the end loan, where the fixed rates are based on what conventional, FHA, VA or Rural Development loans are at the time of application. Check with your lender, but there are extended rate lock options for new home construction loans that can go out as far as 240 days, or eight months.

And one last piece of advice – choose your general contractor very wisely. It’s important to do the research and find a contractor with a good reputation. After all, this is the person drawing on the construction loan that you’ll be paying and, perhaps more importantly, building the structure you plan to call home.

Michael Frerking is senior vice president and director of residential lending at Guaranty Bank. He can be reached at mfrerking@gbankmo.com.

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