Building a new home is a dream come true for most buyers. However, new home construction often requires a more substantial investment than purchasing an established property. Many prospective home builders turn to financing to cover the construction costs associated with a custom-made home. The two primary types of construction loans include one-time-close loans and two-time-close loans.
In both types of construction loans, funds are dispersed by the lender based on a pre-established draw schedule, followed by set amounts released upon the completion of the foundation, and so on as components of the house are built. As construction loans can be more complicated than conventional loans, you’ll want to familiarize yourself with the various aspects of each loan type.
One-time-close loans, also known as “all-in-one” loans or “construction-to-permanent” loans are the most popular type of construction loan. While not available in all areas, this convenient loan is a construction loan and mortgage rolled into a single loan. By utilizing a one-time-close loan, you can avoid having to pay two sets of closing costs on your new home construction. As closing costs can add up quickly, you can typically save thousands of dollars with this loan type.
The one-time-close loan is similar to a standard purchase transaction, but unlike a purchase transaction for an existing home, the value of the new home construction must be determined. For this reason, a one-time-close loan is best suited for buyers who have a clear understanding of the design, anticipated costs, and schedule of the build as these terms can be difficult to modify once the loan is in place. Information such as what types of materials will be used must be provided to the appraiser and lender to help determine the future value of the home.
There are a number of costs that go into building a home, including the following:
- Land Value: In some instances, you may already own the land that you plan to build your new home on free and clear. If not, you may purchase the land under contract at closing with the proceeds from the construction loan.
- Hard Costs: The hard costs of a construction loan are any tangible costs associated with the actual construction of the home, such as labor costs and materials.
- Soft Costs: Soft costs include any costs associated with the home that are not used for the actual building of the home. Examples include architectural fees, engineering fees, and permit fees.
- Allowances: In the construction budget, allowances are given for items that will be selected in the future for the new home construction, such as cabinetry and flooring. Any differences found between the allowances and actual costs must be modified through change orders.
- Contingency Reserve: Having a contingency reserve is crucial to ensure that your loan is equipped to cover upgrades and change orders. This account covers any unforeseen cost overruns that may occur during construction.
- Maximum Loan Amount: If you already own the lot in which your home will be built, you may borrow up to the maximum loan amount based on the appraised value. If the lot is purchased at closing, you may borrow up to the actual cost.
- Lot Equity: The lot equity is the difference between the appraised land value and the land loan. If there is a down payment, the lot will act as a credit.
With a one-time-close loan, there is only one application and one closing. Buyers who choose this loan option also have some level of security due to permanent financing. When rates are locked, buyers know what the interest rate will be and can calculate and budget in advance.
As the name suggests, a two-time-close loan is two separate loans: a short-term loan utilized during the construction phase and a permanent mortgage loan to be paid upon completion of the project. This traditional method of financing for new home construction involves two different closings and possibly two different lenders. While a two-time-close loan may result in paying closing costs twice, there are many other positives associated with this type of loan for your consideration. Change orders are possible with two-time-close loans, and with proper documentation, you may get your money back for any out-of-pocket expenses once you obtain your permanent loan.
As a two-time-close loan consists of two separate loans, you will need to apply and process through the underwriting phase a second time. Depending on a variety of factors such as raised interest rates, higher homeowner’s insurance, or a modification in requirements, you may find that you’re no longer eligible for a permanent loan. If you are not able to gain approval for permanent financing once the build is complete, you may face foreclosure. While a two-time-close offers you the opportunity to get a better deal on a standard loan, you may have to pay twice the closing costs and risk not gaining approval for the second loan.
While having two closing costs can seem like a financial burden, this type of loan can actually have some advantages. With a two-time-close loan, you are not locked into a fixed loan amount from the start. Therefore, if construction costs rise above the agreed-upon loan amount, you will not need to seek extra financing. In addition, you may be able to acquire a lower interest rate with the second loan as most lenders view mortgages as a lower risk than construction loans.
Today many people are choosing to build their home instead of buy. While building a custom home is the ultimate choice for homeowners who seek personalized features and a one-of-a-kind design, financing can be complicated. In addition to finding an experienced general contractor to work with, you’ll want to consider which type of construction loan is best for your build. Carefully weigh the risks and benefits of both a one-time-close loan and a two-time-close loan to determine which is right for your new home construction. Once you’ve made your decision, you’ll be one step closer to owning a new, custom home.
Of course, you will want to have a full consultation with a loan officer before completely making up your mind about your home financing. Be sure to consult with your design-build firm to find a reputable loan group that will keep your project specifics and your best interests in mind. All loan groups offer different rates, fees, and consulting services, so it’s best to shop several options to find the best fit for your home project. Any experienced design-build firm will have several recommendations of loan groups they’ve worked with in the past who integrate seamlessly into the residential construction process.