Custom Home Construction Loan Versus Mortgages

What is a Construction Loan?

By Bob Hinz

What is a construction loan? Do I need it to buy land? Do I need that before I commit to building a custom home? We’ll try answer those questions right now.

First, a construction loan is definitely not the same as a mortgage! That’s a very important point to understand when you’re looking to build a custom home in Denver, Boulder, Colorado Springs, or anywhere for that matter! A lot of people have this idea that any mortgage broker can do a construction loan and that’s definitely WRONG! There are probably a few mortgage specialists out there who might offer construction loans, but I think they’re rare.

Most of the construction loans that we see are loans originating at a bank. Our preference at HomeWrights Custom Homes is ALWAYS with a local bank. We think local banks do the best job. When I say local bank. I mean a bank that has roots right there in your community. Whether you are in Boulder, Denver, or Colorado Springs – find a local lender that knows your neighborhood. Most of our Owner-Builder clients work with local lenders.

CONSTRUCTION LOAN – A VERY LARGE CREDIT CARD

The important thing to understand is that a construction loan is really a very large line of credit. In some ways, it’s like a credit card. You’ll have X number of dollars set aside for you to build your custom home, your credit limit. And in most cases, in addition to those dollars that they have for actual construction, they will also set aside certain dollars to actually pay interest on that loan during construction.

So there’s a very good chance that your construction loan will be structured in such a way that you will not make out-of-pocket payments during construction. The bank will be making those payments for you. And of course, they’re adding that to the overall amount of the construction loan.

“You’re not going to have duplicate payments.”

So at some point in time, the Piper will have to be paid, but it’s a way to get your custom home built without having to make monthly payments. I think that’s, that’s a really important point for people to understand is that you can stay in your current home and you can build your new home with your construction loan. You’re not going to have duplicate payments.

PRIMARY DIFFERENCES BETWEEN CONSTRUCTION LOANS AND MORTGAGES

1. Length of Time: Typical home construction loans are short-term contracts that generally last for about a year. A mortgage has varying terms and gives you anywhere from 10 to 30 years to pay off. A mortgage loan is not usually available for new construction although some lenders may have some hybrid tools that provide a combination of both.
2. Repayment Penalties: Construction loans are short-term financial tools and do not penalize you for early repayment of the balance. Mortgages may have penalties for early repayment. Penalties, if any, vary from lender to lender.
3. Interest Payments: Construction loans charge interest on the amount of the loan used during only during the construction process. If the entire amount allocated is not used, the borrower does not pay the whole interest amount. Mortgages charge the borrower interest on the full amount of the loan.
4. Land Purchases: Construction loans provide new home builders with the upfront funds needed to purchase land on which to build. Typical mortgages do not normally allow land purchases.
5. Construction Cost Pay Off: Remaining costs of custom home construction can be paid off by obtaining a mortgage on the completed home. The terms of your mortgage vary from lender to lender so do your homework. Loan origination fees, interest rates, and number of monthly payments vary. Some terms are negotiable in a competitive market.

I think this is a really important distinction to make during construction. Your construction loan will be growing and the first month you may only owe $50,000. By the eighth month or ninth month or 10th month, you may owe 350,000 or 500,000 or 700,000 or $800,000 on your construction loan. When your custom home is done with all of the construction you can shop for a mortgage lender who will then pay off that construction loan. The construction loan simply goes away. It’s paid off by your new mortgage.

Side Note: If you are planning to act as your own general contractor and you have little or no experience, most lenders are going to shy away from giving you a construction loan. Why? They cannot risk putting out significant money for someone who might have trouble with permits or is unable to find the subcontractors to get the job done in a timely and quality fashion.

In other words, they need to know they are financing a construction project that is going to get done properly. That’s why HomeWrights Owner-Builder clients have a better chance of getting a construction loan because the lender knows HomeWrights has a proven track record of guiding its clients to a successful outcome.