So, we have great plans and an awesome builder. Now we just have to find a way to pay for it. I’m a total finance geek, so this has been kind of fun for me and I figured I might as well share my experience in case someone else is going through this.
I actively started looking at options about 6 months ago and started narrowing it down late last year. Let me start off with a little bit of background on construction financing in general. There are really two types of residential construction loans. 1x Close and 2x Close. There are pros and cons to both, I decided to go with the 1x Close option. Here’s what I see as the pros and cons:
1x Close–you have one loan the whole time, usually you pay a higher rate, but you are locked in
- Pros: Only pay one set of closing costs, if interests rates rise during construction you are already locked, no worry about getting approved for a second loan
- Cons: Can take longer to close initially, stuck with the higher initial interest rate, less banks do this (less competition)
2x Close–you actually have two loans, one interim loan for during the construction and then a second permanent loan that pays off the first one (the second loan is really just a “normal” loan)
- Pros: More banks do this, if interest rates stay the same or get lower you get lower interest rates long term, typically shorter close times
- Cons: Pay closing costs twice, interest rates can go up during construction, could be in a bad situation if house doesn’t appraise or you have approval problems
I’m pretty worried about interest rates rising in the next year, so I was already leaning towards a 1x Close. When I started my research I also found a bank that offers a “float down” option and a 1x Close. They do this by charging a quarter point penalty if you exercise the float down. So here’s how it could work, all these numbers are theoretical. Let’s say I started the loan with a 5% interest rate. No matter what the max rate I will have over the life of the mortgage is 5%. If, by the time the house is completed the prevailing interest rate is 6%, nothing happens, I still have the 5% rate. If the rate is at 4.75%, I still would do anything because with the .25% penalty I’d still have a 5% rate. However, if the rate drops below 4.75% I could decide to float down to the current rate plus .25%. I’m pretty excited by this because I feel like it’s kind of getting the best of both worlds. The only drawback to this bank is that it takes slightly longer to close than some of the other 1 and 2x Close options.
Here’s some things I learned while going through this process:
- There aren’t that many banks that do construction financing–make sure to include looking at local banks they are more likely to do it
- The financing for construction lending is more restrictive than regular financing because it is more risky
- The lender has to approve you and the builder, so make sure you pick a builder that can get approved
- Ask for Good Faith Estimates (GFEs) when comparing the loan options, it can really help you compare the different fees and costs between builders
- Lenders are crazy different when it comes to construction financing, almost all require 20% down, which is what I was planning on doing anyway, but some require 40% down with a 10% cash contingency (wow)
- You’ll need to have a signed contract from a builder to start the application process but you will definitely want to do your research before this as usually the builder will require you to apply within a short time after the contract is signed so you don’t want to limit your research time by waiting until the contract is signed