Building your own home is a huge undertaking, and there are many costs to be encountered along the way. To help ensure that all of these expenses are met in a timely fashion, many homeowners turn to construction loans. These are short-term, variable-rate loans that are priced at short-term interest rates. The lender disburses money to the builder during the course of the construction on an as-needed basis in accordance with a prearranged schedule. Interest is then charged on the amount of money loaned.
While the work is being completed, the homeowner is required to make interest-only payments on the loan. The loan becomes due when the homeowner is issued a certificate of occupancy.
There are two basic types of construction loans:
- Construction-only loan. Provides short-term financing, lasting between six months to a year, which will be replaced by a traditional mortgage once the construction is completed. During the life of the loan, the homeowner makes interest-only payments. The principal is due in a lump sum upon completion of the construction. At that time, the homeowners can apply for a mortgage from the same lender, or they can shop around for a mortgage with lower rates. Keep in mind that if you borrow from another lender, it means going through another closing with all of the associated costs.
- Construction-to-permanent loan. The lender automatically converts the construction loan into a standard mortgage after the homeowners receive their certificate of occupancy. The advantage to this type of loan is that there is only one loan application and one closing. The one major disadvantage is that the homeowner agrees to the mortgage rate and terms before the construction is complete.
Lenders may allow you to lock in your mortgage rate for up to 12 months during construction. However, some lenders also offer a rate lock with float-down option. This entitles the borrower to have the locked interest rates reduced if market interest rates fall during the lock period.
Another special needs loan homeowners may find useful is the bridge loan. Also also known as “swing loans,” bridge loans are a type of short-term financing used when a homeowner wants to buy a new house, but will not have their old house sold before closing on the new one. The homeowner’s current home serves as the collateral for the bridge loan, which will be paid off when the current home is sold.
The loan’s term typically lasts between 90 days to one year. During the term of the loan, the homeowner is required to make interest-only payments. However, there are substantial upfront fees.
The amount you can borrow is determined by the amount of equity you have in your old home. You can either borrow enough money to pay off your existing mortgage and make the down payment on your new home; or you can continue to make your monthly mortgage payments, and only borrow enough to cover the down payment on your new house.
If you haven’t sold your current home by the time the bridge loan expires, you would not only have to pay the accumulated interest, but you would have to refinance the loan into a standard mortgage with fixed monthly payments to cover both principal and interest. This could mean that you might end up having to pay two mortgages, which might force you to sell your current home below market value. For this reason, you should only use a bridge loan if you already have a contract to sell your existing house, and you’re just waiting to close.
Know the Drawbacks of a Bridge Loan
Bridge loans can be an expensive choice over other types of mortgages, such as true home equity loans. They are a type of gap insurance, and generally come with relatively high interest. Many banks charges rates that are up to two percentage points higher than conventional mortgages. They may also require a borrower to pay points as a loan origination fee.
Qualifying for one mortgage can be a tough hurdle, fraught with paperwork. Getting a bridge loan means you are essentially qualifying to carry two mortgages, so don’t expect the process to be easy.
As mentioned earlier, you are paying two mortgages at once, while accruing interest on your bridge loan. If this drags on too long, you may feel forced to significantly lower the asking price in order to get out from under the two-mortgage burden.