With spring arriving early in the Lehigh Valley, we’ve noticed an early uptick in inquiries on how to best finance home construction projects.
Finding a knowledgeable and experienced construction mortgage lender is as important as working with a reputable builder. Consumers need a partner who is familiar with the process and can talk through the nuances of available programs, allowing homeowners to focus on choosing their dream fixtures and finishes without worrying about the financing.
As consumers shop their options, it’s helpful to understand some construction financing basics. The most common forms of construction financing are One-Close and Two-Close loans. These loan programs vary among banks, credit unions, and mortgage companies. Additionally, the size and scope of the project may limit the options.
One-Close construction loans involve one settlement prior to construction. The rate is established at closing and applies throughout the construction period and during the permanent financing period.
During the construction period, interest is paid monthly based on the total draws advanced to-date. Upon completion of the project – typically when the occupancy permit is issued – the financing converts from construction to permanent, and principal and interest payments begin based upon the amortization set at closing.
Since the permanent financing rate is established before construction begins, the worry about a rising rate environment is eliminated. The process is easier and can save money, and borrowers do not need to be reapproved, and they only pay closings costs once.
With a Two-Close construction loan, there is one settlement before construction commences that funds for the new home and a second after completion to secure permanent financing that will pay off the construction loan.
The loan rate applicable during the construction period is typically adjustable and requires monthly interest-only payments. Construction loan terms are similar One-Close loans, although longer periods are more common. After construction is completed, the borrower must secure permanent financing and be reapproved, and the property must be reappraised. Under the Two-Close scenario, the borrower typically arranges to have the permanent financing in place and has to pay closings costs a second time.
In a potentially decreasing interest rate environment, there’s an opportunity to capture a lower rate for the permanent financing when the home is completed. Upgrades resulting in cost overruns from the initial plans may be able to be financed into the permanent mortgage.
How to Choose?
So, if you’re considering residential construction financing, which option is best? As you’ve probably guessed, the choice hinges on a number of factors. Let’s look at some complications for each loan type.
One-Close rates can typically be higher than market rates at the time of closing since the lender is establishing the rate for the construction and permanent periods. Any upgrades or cost-overruns that occur after the loan closes will need to be covered by the borrower out of pocket. Hence, it is advisable to make upgrades/changes before finalizing the construction contract with the builder so the costs can then be included in the financing.
Two-Close loans do not provide interest rate protection on permanent financing until the project is completed; there are typically additional expenses due to the permanent loan closing. Also, if a borrower’s circumstances change during construction, there could be difficulties getting reapproved. The property would likely have to be reappraised, which could play a factor in the permanent loan approval.
An important consideration when choosing between the two options is where interest rates are heading. If rates increase by the completion of the project, One-Close saves money by locking you in to the preferential, lower rate prior to the commencement of construction. If rates decrease, the Two-Close option is preferable.
Ultimately, a number of factors will come into play when considering financing for home construction projects. The best way to make an informed decision is by speaking with an experienced construction mortgage lender to explore your ideal personal options.