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A Look at Construction Loans

By Tabitha Naylor

If you are thinking about building your own new home you will probably need some type of financing. A construction loan is a form of personal financing for building or renovating a house. These types of loans are generally short term loans that apply only during the construction phase. There are several different types of construction loans available. The terms can vary based on the actual construction project.

One-time close loans are the most common type of construction loan. With a one time close loan the lender loans a borrower a set amount of money to be paid back in full during the period of the home construction. So, if a home is expected to be completed in one year, the borrower will make 12 monthly installment payments to get the loan paid off by the time the project is finished. One time close loans have a set interest rate. If the construction takes longer than the time agreed upon in the loan, the borrower may have to pay penalties. Once the home is built, the lender can convert the loan into a long-term mortgage to finance the actual house payment. The construction loan is generally regarded to be the equivalent of one paid year of a long-term mortgage.

The positives of a one-time close loan are that you pay closing costs only one time and you are approved for both construction and permanent financing at the same time. They also provide options for permanent financing which a little provides extra flexibility for the buyer.

A second type of construction loan is the note modification loan. This is similar to the one-time close loan in that it too can be converted into a long term mortgage after the project is finished. A note modification loan has a payment rate that begins small and increases in price as construction is completed. After the project is completed, the borrower can choose a new mortgage payment rate that is locked in or variable. A locked payment rate stays the same even if the value of the house deflates, while an adjustable rate adjusts to the current market value.

A two time close construction loan starts out with a payment schedule that pays off construction costs by the time the house is completed. After the construction is finished, a borrower can refinance a new mortgage payment plan rather than continuing with the same rates. Two time close construction loans are used more often for more expensive building projects because the construction payment rates may be higher than the long-term mortgage payments need to be. With a two close loan you will have double closing costs making it a more expensive type of construction loan but you may benefit from better permanent mortgage rates because you will be working with refinancing rates which are typically more competitive than one time close loan rates. Benefits of a two close loan include greater flexibility to increase the loan amount during the construction phase, lower, or more competitive mortgage rates than a one close loan. You are free to shop around for permanent financing so you can get the best possible rates. The downside of course is that you will be paying closing costs twice instead of once and you will have to go through the loan application and approval process twice. If you can't get permanent financing then you may be faced with foreclosure.

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