How Do Construction Loans Work?

Building a new home is a dream for many Canadians, but unless you’re paying with cash, you’ll need to obtain a construction loan to make your dream a reality. These loans are different from conventional mortgages, so it’s important to understand how they work before you even think about starting the building process.

Types of Construction Loans

According to Maxiron Capital, construction loans are short-term and used to finance a building. There are two main types of construction loans:

  • Standalone: The first loan pays for the construction. Once you move in, you obtain a mortgage to pay off the construction debt. Ultimately, you’re taking out two separate loans.
  • Construction-to-permanent: You obtain a loan to pay for construction. Once you move in, the lender converts the balance into a permanent mortgage. It’s like having two loans in one package.

It’s important to understand the difference between these two types when applying for your loan.

Standalone

Standalone construction loans aren’t as popular as they once were, but it may work out well if it allows you to put down a smaller down payment. If you already own a home and don’t have much cash for a down payment, this type of loan may allow you to stay in your current home while your new home is being built.

But there are some drawbacks to a standalone construction loan:

  • You’ll pay two sets of closing costs: one on the construction loan, and one on the permanent mortgage.
  • You won’t be able to secure a maximum mortgage rate. If rates rise while your home is being built, your permanent mortgage may have a higher-than-expected interest rate.

Construction-to-Permanent

With a construction-to-permanent loan, you only have to worry about one closing. This reduces the fees that you have to pay.

While the home is being constructed, you’ll only have to pay interest on the outstanding balance. The interest rate will be variable during construction, meaning that it will move up or down with the prime rate.

Once the construction is complete, your lender will convert the construction loan into a permanent mortgage. The permanent mortgage is just like any other home loan. You can choose between a fixed-rate and an adjustable rate loan. You can also choose between a 15-year and 30-year mortgage.

With many lenders, you have the ability to lock in a maximum rate once the construction begins. Generally, lenders will require a down payment of 20% with this type of loan. Of course, every lender will have its own requirements.

One other important thing to note: construction loans are generally harder to obtain than a conventional mortgage. Because you don’t have a complete home as collateral, qualifying for a loan can be challenging. The lender will also want to be sure that you can afford to pay the monthly interest payments in addition to your existing mortgage or rent.

Don’t let the challenge of obtaining a construction loan deter you from building your dream home. If you take the time to make sure that your finances are in order and that your credit is in excellent shape, securing a construction loan may not be as challenging as you think.

 

 

 

David Jackson

David is a personal finance expert, a professional male model, and an entertainment writer.