Q: I’m looking to buy a new home or to build the home of my dreams, and for either option I’ll need a loan. It has me wondering; what’s the difference between a conventional mortgage and a construction loan?
A: Traditional mortgages allow a buyer to borrow the funds they need to purchase a new home, and construction loans provide borrowers with access to funds as needed while building a home. Of course, there are nuances, so let’s take a deeper look at the key differences between traditional mortgages and construction loans.
How long does each loan last?
Conventional mortgages are long-term loans that borrowers pay back for years after the starting date, or origination, of the loan. A typical mortgage has a 30-year term, during which the borrower must repay the principal loan amount as well as the interest charges. Some mortgages have 15-year terms, and others can have a payback term of 10 or 20 years, among others.
On the flip side, construction loans are short-term loans that have a payback term of just one year or less. This means the borrower is not stuck making payments on the loan for years, or even decades. However, since the entire loan must be repaid within the year, monthly payment amounts can be significantly higher than traditional mortgage payments.
Do conventional mortgages and construction loans have similar interest rates?
Interest rates on conventional mortgages and construction loans fluctuate along with the Prime Rate. However, in general, interest rates on construction loans tend to be higher than interest rates on mortgages. The higher rates provide protection for the lender, who is taking a bigger risk with the construction loan than they do with a conventional mortgage.
What is the approval process like for each type of loan?
To get approved for a conventional mortgage, you’ll need a decent credit score (generally 620 or higher), a strong credit history, proof of income and a downpayment that is equal to at least 5% of the total loan amount. Most lenders can get borrowers pre-approved for a mortgage in just a few days, but the actual approval process for a mortgage averages 30-50 days.
Conversely, approval for a construction loan can be quicker, but more comprehensive. The lender will usually ask to see details about the planned construction project, including a timetable, a budget and possibly a blueprint or rendering of the intended work. They may also inquire about the hired contractor for the project to verify that you are using a licensed and experienced worker.
In many ways, though, approval for a construction loan is just like approval for a traditional mortgage. You’ll need to have a credit score of at least 620 and proof of income. You’ll also need a downpayment that is equal to at least 20% of the total loan amount.
How are the funds paid out in each type of loan?
One of the key differences between a construction loan and conventional mortgage is the way the funds are distributed. In a mortgage, the entire loan amount is paid out in one lump sum as the borrower takes out the loan. This enables the borrower to purchase their new home immediately upon approval.
A construction loan works differently. Instead of the loan being paid in one lump sum at the onset, funds are paid out in “draws,” or phases, as the construction project progresses. For example, funds may be paid out when each of these stages in the project are reached:
- Delivering the final plans for the home
- Obtaining permits
- Completing the foundation
- Framing out the home
- Installing all drywall, siding, windows and doors
- Installing HVAC systems, electricity and plumbing
- Installing interior trims, cabinets, countertops and flooring
- Substantial completion of the home
- Final completion of the home
If you’re in the market for a new home or you plan on building a home in the near future, you may need to take out a mortgage or a construction loan. [Fortunately, you can take out either kind of loan at Advantage One Credit Union. Our loans offer competitive interest rates, easy payback terms, and a quick approval process for our members. Call, click, or stop by today to get started!]
Whether you choose to build or move into an existing home, best of luck in taking the next steps toward the home of your dreams.
Your Turn: Have you taken out a construction loan and/or a conventional mortgage? Tell us how they differed in the comments.