Construction loans are one or two steps away from permanent financing
One-step vs. two-step construction loans
- One-step loans convert from a construction loan to a standard mortgage upon occupancy.
- One-step loans require only a single closing and no extra closing costs.
- Two-step loans require two closings — one for the construction loan and one for the permanent mortgage.
- Two-step loans are more flexible and may exceed 80 percent financing.
If you want to build your own house instead of purchasing someone else's home or buying a "prefab" from a builder, you will need to get a construction loan to cover the cost of buying the land and building the house. These are typically short-term loans — often 12 months or less — that must be paid in full as soon as you take occupancy of the home.
Just like any other loan, there will be costs and fees that must be paid when you close the deal. The issue is that, unlike standard mortgages, you will be expected to pay off this loan in as little as a year. The only way to do that, unless you are wealthy or just won the lottery, is to get a standard mortgage that will pay off your construction loan and allow you to spend the next 15 to 30 years paying off the house. This so-called two-step loan also will have costs and fees associated with it, and those also must be paid at closing — your second closing in a year.
What is a one-step construction loan?
There is an alternative, however. You can get a "one-step" — or construction-to-permanent — loan that acts just like a construction loan for the first 12 months and then transforms into a 30-year fixed mortgage once the certificate of occupancy is issued and you take possession of the home.
This may seem like the ideal way to finance building your own home, but there are some times you may want to use a two-step construction loan. For one thing, some lenders will provide more than the normal 80 percent financing on a two-step loan, but not on a construction-to-permanent loan. So, if you cannot put up 20 percent of the cost of construction, you may want to go with a two-step loan.
How does a two-step construction loan work?
The two-step loan also allows you to shop around for the best deals on a standard mortgage while the house is being built. If you think interest rates are likely to drop during construction or you think you can find a better mortgage product at a different lender than where you got your construction loan, it might be worth paying those closing costs again.
Using a two-step loan may also give you more flexibility with construction-schedule issues and cost overruns (whether due to the project's scope changing or external issues out of your control). Because everything must be set up on the subsequent mortgage at the beginning of the process — even before construction begins, one-step loans may lock you into a final occupancy date and mortgage amount that you simply cannot meet if life throws you a curveball during construction.
Check with your lender to see how these issues would be handled in either a two-step construction loan or a construction-to-permanent loan before you decide, and then weigh their answers against the savings and convenience of avoiding a second loan closing.