Residential Construction Loans Explained
Short-Term and All-in-One Financing Options

Steven wrote me asking about residential construction loans, mortgages designed for building homes. There are two main types of building loans and a borrower's choice will depend on local availability, monetary resources, and personal preference.

The first method is short-term financing. During construction, incremental funds are issued to the contractor in draws to pay for labor and materials, as needed. After construction is complete, the temporary construction loan must be paid in full.

The second method is all-in-one financing which rolls together both the short-term construction and permanent financing aspects into one loan.

1. Temporary Short-Term Residential Construction Loans Continued

Short-term construction loans are temporary in nature. These loans must be followed by a permanent mortgage refinance after construction is complete. Banks generally require them to be paid back in one year.

Sometimes a builder applies for the temporary financing, other times the homeowner applies. Either way, the homeowner is responsible for arranging the eventual permanent financing.

Advantage: When the borrower refinances the short-term construction loan, the permanent interest rate is usually lower than the rate offered on all-in-one loans.

Disadvantage: If borrower fails to prepare properly or encounters a hardship while the home is being built, there can be a scramble for permanant financing at the end of the year. Talk about stressful.

2. Permanent All-In-One Construction Loans Continued

Another type of building loan is the construction-to-permanent, also known as the all-in-one. Financing encompasses both stages, short-term construction and long-term permanent, in one lending process.

Beginning with a short-term construction loan, it converts to a permanent mortgage upon completion of the dwelling.

Advantages: The homeowner only incurs one set of closing costs for both aspects of the financing and can lock in their interest rate sooner.

Disadvantage: Interest rates for all-in-one construction loans are generally higher than the rate on a refinance used to pay off short-term financing.

Steven Questions Kate About Building a House

Background: Steven wants to build a house in addition to keeping his current home that he owns free-and-clear.

Hi Kate, I am interested in building a house but prefer to keep my current home too. It has no mortgage and the market value is around $60,000.00. I am thinking of renting it out or selling. My decision really lies in the money matter.

I am one of the people who has always paid my bills and that is why I am 35 years old with a mortgage paid off. However this has left me with only a 650 credit score because I do not have a lot that I now owe on.

So with that, I am not one who has any real money saved up but I want to build a new home on a different piece of land. I want to build a new home but want to keep my current place separate for security reasons. Thanks, Steven

Kate Answers Steven

Steven's question:
 Will I have to use my current property to obtain a residential construction loan without putting up any money out of pocket?

Kate's answer: Down payments for residential construction loans can come from a cash out mortgage refinance of another home with existing equity. Since your current house is owned free and clear without a mortgage, this is a strong possibility. It does mean the current house will acquire a lien.

Steven's question: If so will I be able to separate the two properties at the mortgage closing?

Kate's answer: Since your current home is worth $60,000, you could refinance it to borrow the down payment needed for building a house. The remainder of the funds to build the new house would come from either a temporary construction loan that will need to be refinanced or a long-term all-in-one. (See above for more explanation.)

Steven's question: How can I build a new home but keep my current place separate for security reasons?

Kate's answer: Actually, in this example, each home has its own mortgage. Although both have a lien, they are separate from each other.

Unique Home Buying Information

Here is your next stop in my home buying series. When private mortgage financingoriginates between family members, property tax and mortgage interest deductions frequently come into question.

You Can Ask Kate Too

What if you could ask a mortgage insider anything you wanted regarding construction loans and other matters pertaining to buying a house? Now you can!

Ask Kate is specifically designed to answer your questions and create dialog regarding home buying and mortgage financing.

You'll also find a wealth of information at Kate's Best Mortgage Rate Blog packed with the latest additions to this website, interest rate updates, and a fresh approach to affordable homeownership.

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Learn the differences between Residential Construction Loans - Mortgages designed for building homes.

When private mortgage financing originates between family members, these questions arise.

Ask Kate About Home Buying - Go here to ask me a question.

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How to Buy a House Questions and Answers I.

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