Considering Your Financing Options: The Differences Between a Mortgage Loan and Construction Loan
When you're in the market for a new home, you may be wondering what kind of loan is right for you. Should you get a mortgage loan or a construction loan? Here, we'll break down the key differences between these two types of loans so that you can make an informed decision about which one is right for your needs.
A mortgage loan is a loan that is used to finance the purchase of a property. Mortgage loans are typically repaid over 15 to 30 years, making them an excellent option for those looking to finance a long-term investment. One of the key benefits of a mortgage loan is that it allows you to build equity in your home over time. As you make payments on your mortgage loan, the value of your home will increase, allowing you to build wealth through homeownership.
There are a variety of mortgage loans available, each with its own benefits and drawbacks. The most common types of mortgage loans are:
- Fixed-rate mortgages: With a fixed-rate mortgage, the interest rate remains the same for the entire duration of the loan. This type of mortgage can be a great option for those who want predictability and peace of mind, as they know exactly what they will be paying each month.
- Adjustable-rate mortgages: An adjustable-rate mortgage (ARM) features an interest rate that can change over time. This can be risky for some borrowers, as their monthly payments could potentially increase if the interest rate rises. However, ARMs can also be a good option for those who want to take advantage of low-interest rates and plan to sell their home within a few years.
- Home equity loans: A home equity loan is a type of loan that allows you to borrow against the value of your home. This can be an option for those who need access to cash but don't want to sell their home. In addition, home equity loans often have lower interest rates than other types of loans, making them a cost-effective option in certain cases.
When considering which type of mortgage loan is right for you, it's important to weigh each option's benefits and drawbacks and consult with a qualified lender. They will be able to help you choose the loan that best suits your needs and budget.
A construction loan is a loan that is used to finance the construction of a home. Construction loans are typically repaid over a period of 12 months and have higher interest rates than mortgage loans. One benefit of construction loans is that they can be used to finance both the purchase of land and the home's construction. Another advantage is that most of the time, there is no need for a down payment. However, one downside is that with some lenders, you will need to pay closing costs twice—once for the land and once for the construction of the home.
Construction loans come in two different types: construction-only and construction-to-permanent.
- Construction-only loans only cover the cost of building, after which you either have to pay off the loan or get a mortgage for long-term financing. However, you will need to pay closing costs twice with this type of loan.
- Whereas, with a construction-to-permanent loan, you can convert your home's build into a conventional mortgage. This might be beneficial for people who couldn't afford initial building costs outright. In addition, you're able to lock in rates at the time of closing and only have to worry about paying closing fees once!
Let's see how construction loans work:
On average, it takes six to eight months to build a home. For the purpose of this example, let's assume that the total cost for your land and home is $600,000. This is the sale price. You plan on making a down payment of $120,000 (20%). So you will borrow $480,000 through a construction loan from the bank. The bank only charges interest on the amount of loan drawn during construction; at current rates (~5%).
ESTIMATED INTEREST PAYMENTS DURING CONSTRUCTION
Month 1: $220.00
Month 2: $575.00
Month 3: $818.00
Month 4: $1205.00
Month 5: $1669.00
Month 6: $2015.00
Month 7: $2578.00
Total Estimated Interest during construction: $9,080.00
Remember that this money does not go towards your principal balance, and you will continue to pay it until you close on the new home. Also, if the build time takes longer than expected, these interest payments will continue until the house is complete and your permanent financing is finalized. Also, if the build time takes longer than expected, these interest payments will continue until the house is complete and your permanent financing is finalized.
It's important to note, however, that your loan balance becomes due when your home construction is complete. At this point, you can either pay the remaining balance in cash or convert your loan to a standard residential mortgage.
Because these loans are complicated, look for a lender that specializes in construction-to-permanent loans and is not new to the business. Unfortunately, not all lenders will offer this type of loan. Regional banks and credit unions can be other good alternatives.
Be aware that construction-to-permanent loan options are often more expensive than traditional mortgages, so make sure to compare rates among different lenders before settling on this option.
If you’d like some more information or have a particularly nagging question, feel free to contact us. We’d be happy to help.