The method of financing used when a borrow- er contracts to have a house built,as opposed to purchasing a completed house.Construction can be financed in two ways. One way is to use two loans, a construction loan for the period of construction, followed by a permanent loan from another lender, which pays off the construction loan. Borrowers who use two loans must decide whether they will take out the construction loan, or have the builder do it. The second approach is to use a single combination loan, where the construction loan becomes permanent at the end of the construction period.
Some lenders (primarily commercial banks) will only make construction loans. Others will only make combination loans. And some will do it either way.
Two Loans Versus One Loan: Two loans mean that you shop twice and incur two sets of closing costs. One loan means that you shop only once and incur only one set of closing costs. But, to do it effectively, you must shop construction loans and permanent loans at the same time.
Construction loans usually run for six months to a year and carry an adjustable interest rate that resets monthly or quarterly. In addition to points and closing costs, lenders charge a construction fee to cover their costs in administering the loan. (Construction lenders pay out the loan in stages and must monitor the progress of construction). In shopping construction loans, one must take account of all of these dimensions of the “price.”
Lenders offering combination loans typically will credit some of the fees paid for the construction loan toward the permanent loan.
The lender might charge four points for the construction loan, for example, but apply three of the points toward the permanent loan. If the borrower takes the permanent loan from another lender, however, the construction lender retains the three points. This credit plus the one set of closing costs are major talking points of loan officers pushing combination loans.
The rebate offered on combination loans makes it difficult to compare these loans with the two-loan alternative. For example, lender A offers a construction loan at four points with three points applicable to a permanent loan, while B offers an untied construction loan at two points. Going with Ameans saving one point on the construction loan but this is no bargain if A's terms on permanent loans are not competitive.
Suppose A offers a permanent loan at 6% and three points, while lender C offers the same 6% loan at one point. Then if you selected A, you would pay a total of four points on both loans, but if you had selected B for the construction loan and C for the permanent loan you would have paid only three points in total. A is above the best price available in the permanent loan market by more than it is below the best price available in the construction loan market.
Further, once you accept a combination loan deal that involves a significant rebate from the construction loan, shopping other
lenders for a permanent mortgage after construction ends is likely to prove fruitless. So long as the combination lender is not above the market for permanent loans by more than the rebate plus closing costs, you cannot do better by finishing the deal with another lender. You're hooked!
This means that you cannot properly assess a lender's combination loan without comparing that lender's terms on permanent loans with those of other permanent lenders. You should shop construction loans and permanent loans at the same time. If the combination lender is above the market on permanent loans by an amount that is less than the saving on the construction loan plus closing costs, you go with the combination loan. Otherwise, you go with two loans.
If you go the two-loan route, you have the option of having the builder take the construction loan. Then you have only the perma-
nent loan to worry about.
Should the Builder Finance Construction? The advantage of having the builder finance construction is that you need to take out only one mortgage, and you have assurance that the builder has sufficient financial capacity to do the job. Further, a builder paying interest on a construction loan has an incentive to get the job done as quickly as possible.
The downside is that you don't know what you are paying for the financing because it is embedded in the price of the house.
Since the builder must include the financing cost in the price before the construction period is known, his inclination may be to assume a longer period (and therefore a higher financing cost) than is actually the case.
In addition, the builder must have title to the land in order to obtain construction financing, and switching title is costly in some
states. Finally, a builder who owns the property and is on the hook for the loan may be reluctant to make any modifications in the design that would negatively affect its marketability in the event that the deal falls through.