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Home construction modelLots of people have an idea of what their dream home looks like, and for most of those people, the only feasible way to get that dream home is to build it themselves. In order to do that, though, a construction loan is generally needed. Construction loans can be complex, though, due to the fact that there is a much higher risk that is taken on for the lender (because what assets are left to take if the borrower doesn’t finish the home?).

Because of that added risk, most construction loans are short-term and paid out in specific phases during the construction process. The interest rates are generally much higher, as well. In order to adequately plan out a construction loan, the lender will have a process that requires the borrower to offer detailed construction plans for the home, as well as a timetable and budget that is approved by a licensed professional.

There are two main types of construction loans that anyone considering getting one should know about early in the process, to know what will work best for them…

Construction-Only Loans

A construction-only loan typically accompanies a separate loan. The actually construction-only loan is used to pay for the construction of the home and is only in effect for a year (or even less). After the completion of the home, the outstanding balance of the construction is then put into a standard mortgage that is paid out over time.

This type of construction loan requires a lower down payment than construction-to-permanent loans. It is ideal for homebuyers who don’t have a lot of liquid cash but may have their net worth tied up in other assets. One downside of this type of loan is that it will require the borrower to pay for the closings costs of two separate loans.

Construction-to-Permanent Loans

A construction-to-permanent loan can be appealing to lenders because it transitions from a construction loan to a traditional, permanent mortgage. It is also an attractive option for borrowers because it can be easier to be approved for, and they will only need to pay the closing costs for a single loan when they are actually getting two loans.

When getting a construction-to-permanent loan, the borrower is only responsible for payments on interest, so they don’t need to pay down the principle yet. This can be a relief for borrowers, but it comes with the caveat that the payments are variable, meaning that they change from month-to-month. The details of the permanent mortgage, once transitioned, are negotiated and approved separately, so the properties of those payments can vary.