3 Common Ways to Finance Home Construction
There are several ways to finance home construction and each could be the “best” choice given varying circumstances. There is not a single “best loan” to fit all situations. The three most common methods are; a Home Equity Line of Credit, a “cash-out” Refinance and a Home Construction Loan.
A Home Equity Line of Credit or a HELOC as many lenders referred to it usually comes in the form of a second mortgage. They generally have the lowest total closing costs of the three methods and you can borrow the funds on an “as needed” basis rather than as a lump sum. However, HELOC’s are limited to your home’s existing equity without regard to value added by new construction. This type of loan usually involves a rate that can change monthly and is based on one of the more volatile indices like the Prime Rate or LIBOR. This may be favorable in stable economic times for a short number of years, but is considered risky when the economy begins advancing and rates start to rise.
A “cash-out” refinance also draws excess equity from your home by refinancing your current mortgage and increasing the balance beyond what you currently owe. The extra funds are known as “cash-out.” This provides a lump sum that can then be used for construction. The attractive features are that you can obtain a long term fixed rate with set monthly payments that will be far more affordable over the long term than a line of credit. However, you’ll be paying closing costs based on the entire new loan amount rather than just the amount of funds used to build. Unfortunately the loan is based on your home’s current equity without regard to the cost of construction, which quite often provides just a small fraction of the funds required.
Construction or renovation of a luxury home usually comes with a price tag lying far beyond the savings of most homeowners or equity currently available in their home. The true value of a home construction loan begins with a loan amount based on the Future or “As-Completed” value of the home. Homeowners Tim and Kimberly Peterson of Pacific Palisades, California put it well when they said, “we found it astonishing that we were able to borrow the entire cost of construction and also include the cost of very expensive architectural plans. We assumed we would need to liquidate and use thousands dollars worth of investments in order to have our home built. By choosing the Single Close loan where the loan amount is based on the future value of our home we were able to keep our well-placed investments hard at work while we built our dream home.”
There are two primary types of construction loans; the construction-only and the Single Close or One-Time Close (OTC). The construction-only loan is less attractive, but oddly, the more common. The Single Close is really the premier loan with which to finance home construction in America today and the savings can be huge once you know what to look for.
If you know what to look for the savings can be huge and the Single Close provides so many advantages, including cost savings, ease of process, financial control, accountability and risk management.
Each time a mortgage loan is originated there are costs associated with it that often run several thousand dollars; appraisal, title insurance, escrow fees, lender fees and more. These can often total 1-3% of the full loan amount. With a Single Close or construction-to-permanent (CTP) mortgage the process is simplified and the savings can be quite large. Not only are you eliminating the need for a second or third set of fees, but you can often lock-in a single interest rate before construction begins. James Simon of Los Angeles, California recently shared this; “it takes me nearly past the edge of comprehension to think I almost settled for a construction-only product to finance building my home. My home was to take 18 months to complete and I was told the only loan available would mean I couldn’t lock-in a permanent rate before my home was complete. However, by choosing a Single Close loan and locking my permanent rate before construction begins I am certain I will have saved several tens of thousands of dollars in interest.”
A Single Close loan also greatly reduces the risk of financial loss. It ensures funds borrowed are disbursed to the builder and suppliers only after a specific portion of the work has been completed, properly inspected and the necessary lien waivers have been collected. This process of Fund Control is a series of steps that act as checks and balances aimed at reducing the chance of your loan proceeds to be improperly diverted or have a Mechanic’s Lien placed against your title for non-payment. Marc Metzger, owner of Granite Loan Management in Denver, Colorado shared a true story on the value of Fund Control; “in the normal course of a pre-release draw inspection for a 2nd home being built in Park City, Utah our inspector found slate roofing tiles valued at $34,000 were missing from the construction site. Upon further checking it was learned the builder had re-routed delivery of the materials to his mother’s home. His intention was to re-roof his mother’s home at the borrower’s cost and claim the materials had been stolen. Not only were the materials recovered, but a dishonest builder was found out and replaced before an even larger problem could rise.”
The Single Close loan and its carefully designed set of procedures provide the premier way to finance most large size home construction projects, including ground-up construction, complete demolition and rebuild or major renovation and addition.
Written by Ty D. Kirkpatrick, an author and expert on Home Construction and financing it for over 25 years.