Summary: A construction loan is used to finance construction. It is a line of credit like a credit card that is paid off by a mortgage loan upon completion of the new home.
Note: Construction Loans have become difficult to obtain. Owner Builder Construction Loans have become even more difficult to find. In answer to many of your questions as to where to find New Home Construction Loans, read my article How to Get a Construction Loan.
Construction to permanent financing: As the name implies, there is one closing (signing papers) for both the new home construction loan and the permanent home mortgage (end financing)
One closing means one set of closing costs, which is the main advantage for this type of loan. Since the lender's policies on these types of loans vary so much and change so fast, you will need to talk directly to a lender when you are ready to shop for your loan.
A small disadvantage of this loan is that the dollar amount of both the construction loan line of credit and the permanent home mortgage (end financing) cannot be increased. If the house ends up costing more than you planned, and your loan isn't large enough, you will end up taking out another loan and paying for a second closing anyway thus defeating the advantage of a “one-time close” construction loan.
Note: These construction loans are not always available to owner/builders as lenders feel that an owner/builder cannot estimate costs accurately and is not a good risk. However, as I mentioned in chapter one, by using a building consultant, a site supervisor, or a contract to build from a builder (that the lender approves) a one time close construction loan most likely will be obtainable, often with 90% financing of all costs, including land, as long as the loan doesn’t exceed 90% of the appraised market value of the completed house.
The two-time close construction loan: This type of construction loan involves two separate loans with two sets of closing costs, but offers you more flexibility. If you do decide to increase the amount of your construction loan (and if you qualify), it's no big deal. You will pay off the construction loan with a refinance mortgage loan. Refinance mortgage loans are very competitive, and you might get a better deal by being able to "shop" for the loan that you'll paying on for years.
How a Construction Loan Works:
A construction loan is like a credit card with a low interest rate and a high credit limit.
If you were able to secure a mortgage for the construction of your new house and the lender were to give you a check for that amount before you started, both you and the lender would be in trouble. The lender, because they just loaned a large sum of money on a house that doesn't yet exist; you, because you’d have to pay interest and principal on that loan before you even broke ground for your new house. Considering the interest expense, this could mean you would have to pay a large amount of interest each month on a nonexistent house, along with your regular monthly fixed expenses for items such as food and rent.
Enter the construction loan. The money you need to pay for construction costs, even the land in some cases, is disbursed to you as the building progresses. You pay only interest, no principal, on the total amount lent to you for any given month during construction. For example, if the house is 20 percent complete after the first month, the lender, after a physical inspection of the progress of construction, will advance 20 percent of your total to you to pay your bills. If your total construction loan is $300,000, then you will receive 20 percent of $300,000 which is $60,000.
The house is now 20 percent complete, you are one month along in progress, and you have paid no interest yet. And you won’t have to until next month, when you will start to pay the interest only on the money you received.
Construction loan interest is a "cost to build" item of any new home, whether you build it or I build it for you. It’s not even part of the builder’s overhead. It’s a cost like lumber and nails. Treat it as such and plan for it, along with other financing charges, and it won’t bother you. Think of all the money you are saving by being your own general contractor.
There is a considerable time period during construction in which the house is progressing toward completion, but you haven’t yet received bills for materials. It should take approximately six months to complete the house, and because of the billing time lag from suppliers and the loan interest being one month or more in arrears, during those six months you will have had an average of only 40 percent of the total money available disbursed to you. This is an approximate figure, obviously, as is the amount of time needed to complete your house. I’m merely pointing out that you won’t pay interest on the full amount of your mortgage until the house is complete. At that time the lender will complete the disbursement of the construction money and convert the loan to a permanent mortgage for 15 to 30 years, or you can refinance the construction loan with the "permanent" end financing (mortgage) that you were pre-approved for. Only then will you be making your full payment of principal and interest. But by then you will have moved in to your dream house. If that sounds simple, it is only because it is.