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Which Type of Construction Loan Should You Choose? - Sedgewick
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Which Type of Construction Loan Should You Choose?

Which Type of Construction Loan Should You Choose?
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Unless you’re paying cash for your home building project, you’ll need a construction loan. And if you don’t own your land already, it can pay for that too. New Home construction loans are usually combined with either a conventional loan, most often a 30 year fixed or adjustable rate mortgage, or an FHA loan (Federal Housing Administration Loan). This can be done in one of two ways:

  1. One-Time Close Construction Loans (also called One Step Construction Loans)
  2. Two-Time Close Construction Loans (also called Two Step Construction Loans)

For all practical purposes, construction loans are like short-term lines of credit. The difference is, the bank controls how and when money is released. It’s usually done as a series of “draws”, which are pre-determined stages in the construction process; like when the foundation is complete and when framing is done. While each lender can structure these draw stages differently, there are typically 5 – 7 draws during your new home construction process. When draws are paid to your builder, you pay interest only on each draw. As the total amount drawn increases, so does your interest payment. The balance due at the end of the construction process is then paid by your mortgage lender. This becomes your permanent mortgage.

One time close construction loans are handled by a single lender. This means, you’re approved at the beginning for the construction loan and your final mortgage. There’s only one approval process and one closing. These typically have a slightly higher interest rate because their risk is higher at the beginning.

With a one-time close construction loan, you negotiate terms on the mortgage rate in the initial loan; either fixed or variable rate mortgage (ARM). So, with the expected increase in interest rates, you would likely benefit from a fixed rate over a variable rate mortgage. With a fixed rate mortgage, you can lock in the current rate and not worry about the rates going up again. However, with a variable rate mortgage, you take a little gamble to see if rates might come down when your home is complete.

Pros of one-time close construction loans

  • You pay just one set of closing costs
  • You are approved at the same time for both construction and permanent financing
  • Multiple options for permanent financing give you flexibility

Cons of one-time close construction loans

  • If you spend more than the construction mortgage, you may need to take out a second loan, and pay additional closing costs
  • Permanent rates may be a little higher than with a two-time-close loan

On the other hand, two-time close construction loans can involve two lenders: one lender for the construction process and one for your mortgage. Two approvals and two closings. Because of the two closings, your total closing costs are typically a little more. Although, you may prefer the two-time close because you can shop around for the best interest rate on the mortgage. However, in the current environment with interest rates on the rise, it may be beneficial to lock-in your interest rate sooner rather than later.

The timeline of construction is usually less rigid than one-time close loans, where there can be penalties if you don’t meet the time schedule. There’s also more flexibility in a two-time close should you desire to increase your loan, for instance adding something later. So, if you’re planning to build a custom home, and don’t have a firm idea of what you want, you may want to consider a two-time close construction loan even if that means a higher mortgage interest rate in the end.

Pros of a two-time close loan

  • Greater flexibility to modify the plans and increase loan amount during project
  • Mortgage rates are often lower than in one-time-close loans
  • You are usually free to shop around for permanent financing

Cons of a two-time close loan

  • You need to be approved twice and pay closing costs twice
  • You face risks if your circumstances change when you apply for permanent financing
  • Interest rates may change for the worse before you can close on your permanent loan

The most important thing is to make sure you understand all your options and make the best choice for you.

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