Construction loans usually are meant to be short term and then are replaced by another more permanent loan once a home is built. There are two basic types of construction loans:
The borrower only pays interest during the construction phase of the project. The lender then automatically converts the loan to a mortgage after the home is built.
One of the biggest advantages of this type of construction loan is that there is only one application and one closing. Consumers pay just one set of costs for many of the required underwriting steps such as recording the mortgage, conducting a title search on the property, and confirming credit. While this doesnt allow the consumer to shop around for the best deal on permanent financing, many borrowers have peace of mind knowing they have a mortgage commitment. In addition, these loans usually have low or no up-front fees.
This arrangement requires separate loans for construction and mortgage. First, the borrower applies for and pays closing costs on the loan for the construction. This loan typically has a six-month to one-year term. Only interest is paid during the building stage, and the entire principal amount is due at the end of the term. In addition to the other fees connected with the construction-only loan, borrowers also can expect an up-front service charge ranging from 1% to 2.5% more than the prime rate. Next, the borrower must apply again for the mortgage and pay another set of closing costs. The two loans can come from the same lender or different lenders.
The construction-only loan is appealing to some consumers because of the flexibility it offers. The borrower can shop for the very best mortgage available while the home is being built and isn`t locked into one (usually higher) interest rate.