Financing for new construction as well as financing an existing home both involve getting a loan with real estate as the collateral. They’re both the same in that manner but clearly different in others. Let’s look at the differences between financing new construction and financing an existing property.
When someone decides to buy an existing home and take out a new mortgage, the options are nearly unlimited. First, there are fixed rate and adjustable rate mortgage options. Fixed rate programs simply mean the selected interest rate remains the same throughout the life of the loan. This provides easier financial planning for those who intend to keep the property for the long term, knowing what their mortgage payment will be in say year 28. The payment will be exactly the same as in year 1. These loans can have terms ranging anywhere from 10 to 30 years, with some ‘portfolio’ type mortgages being as long as 40 years.
An adjustable rate mortgage as the name implies can adjust but to do so the loan must follow very specific rules laid out in the note. An adjustable rate mortgage, or ARM, can adjust based upon a selected index and then adding a margin to that index to arrive at the new mortgage rate until the next adjustment period. There are also consumer protections called ‘caps’ that limit not only how much the rate can move at the new adjustment period but also how much the rate can adjust over the life of the loan. ARMs also can have various terms. In general, for both types of loans, the shorter the term, the higher the monthly payment but at the same time there is less overall interest paid over the life of the loan.
A construction loan is used to finance new construction. Mortgages used to finance an existing property cannot be used to finance new construction. Construction loans are issued only for as long as it takes to build the home. Once the home is completed, the construction lender sends out an inspector for one last inspection to make sure the home is finished and is ready for occupancy. When this determination is made, the construction loan must be replaced by a permanent mortgage, the same types of home loans used to finance an existing property.
When a construction lender provides financing for a new home, the loan amount is based upon the plans and specifications laid out by the builder. All the costs, both ‘hard’ and ‘soft’ are added up. These loans also typically ask for more initial equity from the borrower. While a home for an existing property can have very low down payments, sometimes zero, a construction loan might ask for a down payment of something like 20%. If the borrowers already own the lot on which to build, the lot typically accounts for the initial 20% equity required. A loan for an existing home can be found at a mortgage company or through a buyer’s own bank, while a construction loan is usually provided only by a bank.