Two Methods for Financing a Custom Home
Watch the video above (17 minutes) or read on for further information.
There are two methods for financing a custom home:
The first method is called a “2 Step” loan.
Step 1 is the construction loan which provides the money to build the home from the ground up. This includes the purchase of the lot if necessary.
Step 2 is the permanent loan that most folks are already familiar with. It pays off the construction loan and then the homeowner begins making regular monthly payments just like any other type of mortgage loan.
Since there are two steps and two loans the homeowner must attend two closings at the title company.
The second method is called a “1 Time Close” loan.
As the name implies, there is only 1 step. The construction loan and the permanent loan are handled at the same time through one application, and one closing at the title company before home construction has begun.
There is still a construction loan to provide the purchase of the lot if needed, as well as the money to build the home. And there is still a permanent loan that replaces the temporary construction loan when the home is ready to move into. It is all handled together in one title company closing right up front.
Advantages and Disadvantages of the “2 Step” loan vs. the “One Time Close” loan:
Flexibility with regard to loan amount changes
A “2 Step” loan is good because it has the flexibility of making changes in the loan amount during construction. For example if the homeowner wishes to add a swimming pool or finish out a media/bonus room upstairs, the 1st step construction loan can be modified to include such improvements.
A “One Time Close” loan does not possess this flexibility. Remember that the permanent loan was completed and closed before construction ever began. As a result it is frozen and cannot be changed.
Flexibility with regard to future job changes
A “One Time Close” is good because when the borrowers are approved for both loans prior to the start of construction there is no requirement to submit new documentation and be re-approved prior to moving into the new home. If planned or even unplanned job changes occur after the start of construction it does not affect the homeowner’s ability to move in to the new home.
A “2 Step” loan does require a re-approval for the permanent loan prior to moving into the new home.
Closing Costs
Closing costs are typically about the same regardless of which method the borrowers choose. Ask your loan officer to prepare a good faith estimate to compare the closing costs. Normally the good faith estimates are within $200-$400 of each other.
Interest Rate During Construction
The interest rate during construction is typically Prime + 1% under either method. However, the “One Time Close” offers several variations for which the rate may be lower during the construction phase. But there are costs associated with such choices, so ask your loan officer to explain the details.
Interest Rate For the Permanent Mortgage
Typically, the rate for the permanent mortgage is the same regardless of the “2 Step” or the “One Time Close” loan. However, the 2 Step sometimes is a better choice because it allows the loan officer to shop your loan from a much larger population of lenders-many of which do not offer a One Time Close option-but which sometimes have a better permanent rate.
Capping the Interest Rate on the Permanent Loan While Your Home is Being Built
Either method allows the borrower to protect themselves from significant increases in interest rates while the home is being built by ‘capping’ the rate.
While it is possible to ‘lock’ the rate at today’s best rate and hold it for 6, 9 or even 12 months, it is incredibly expensive and not recommended.
Rather, the vast majority of clients choose to identify today’s best rate and place a ceiling above it at about ½% higher than today’s best rate. There is no charge for doing this and if rates fall below today’s rate at the completion of the home, the borrower may float down to the better rate.
For example, if the rate today is 6.125% it can be capped at 6.625%. If rates increase to 7.25% or more, the borrower is protected from such an increase and limited to no more than 6.625% on the permanent mortgage. If on the other hand, rates decline to 5.75% the borrower may float the rate down to 5.75% for no charge or fee.
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While there are additional details that your loan officer will discuss, this is a pretty complete overview of construction financing and should provide a good foundation for deciding which loan program is right for you.
