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Building your own home is a huge undertaking with many costs along the way. To make sure they can meet these expenses in a timely fashion, many homeowners turn to construction loans.
These short-term, variable-rate loans are priced at short-term interest rates. Your lender pays the builder on a prearranged schedule as your home is being built.
While the work is being completed, you make interest-only payments on the loan. When your home is complete and you can move in, the bridge loan gets paid off a new, permanent mortgage.
There are two basic types of construction loans:
1. Construction-only loan.
Provides short-term financing, lasting between six months to a year and gets replaced by a traditional mortgage once the construction is completed.
During the life of the loan, you make interest-only payments. The principal is due in a lump sum upon completion of the construction.
At that time, you can apply for a mortgage from the same lender, or shop around for a mortgage with lower rates.
Keep in mind that if you borrow from another lender, it means going through another closing with all of the associated costs.
2. Construction-to-permanent loan.
The lender automatically converts your construction loan into a standard mortgage after your home is complete. The advantage to this type of loan is that there is only one loan application and one closing. The one major disadvantage is that you have to agree to the mortgage rate and terms before the construction is complete.
There are lenders who allow you to lock in your mortgage rate for up to 12 months during construction. However, some lenders also offer a rate lock with float-down option. This entitles the borrower to have the locked interest rates reduced if market interest rates fall during the lock period.
Bridge Loans
Another special needs loan homeowners may find useful is the bridge loan. Also known as “swing loans,” bridge loans are a type of short-term financing used when you want to buy a new house, but you haven’t closed on the sale of your old house. Your current home serves as the collateral for the bridge loan. You pay off the bridge loan with the proceeds from the sale of your old home.
Bridge loans typically last between 90 days to one year. During the term of the loan, you typically make interest-only payments. However, there are substantial upfront fees.
The amount you can borrow is determined by the amount of equity you have in your old home. You can either borrow enough money to pay off your existing mortgage and make the down payment on your new home or you can continue to make your monthly mortgage payments, and only borrow enough to cover the down payment on your new house.
If you haven’t sold your current home by the time the bridge loan expires, you would not only have to pay the accumulated interest, but you would have to refinance the loan into a standard mortgage with fixed monthly payments to cover both principal and interest.
This could mean that you might end up having to pay two mortgages, which might force you to sell your current home below market value. For this reason, you should only use a bridge loan if you already have a contract to sell your existing house, and you’re just waiting to close.
Bridge loans can be an expensive choice over other types of mortgages, such as true home equity loans. They are a type of gap insurance, and generally come with relatively high interest. Many banks charges rates that are up to two percentage points higher than conventional mortgages. They may also require a borrower to pay points as a loan origination fee.
Qualifying for one mortgage can be a tough hurdle, fraught with paperwork. Getting a bridge loan means you are essentially qualifying to carry two mortgages, so don’t expect the process to be easy.
As mentioned earlier, you are paying two mortgages at once, while accruing interest on your bridge loan. If this drags on too long, you may feel forced to significantly lower the asking price in order to get out from under the two-mortgage burden.
