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When it comes to financing a new home you have two main options – a building loan or a mortgage. But what exactly is the difference between these two types of home loans and how do you know which one is right for you? In this comprehensive guide, we’ll break down the key differences between building loans and mortgages so you can make an informed decision.
What is a Building Loan?
A building loan, also known as a construction loan, is a short-term loan used to finance the construction of a new home. The funds from a building loan can cover costs like:
- Land purchase
- Materials
- Labor
- Permit fees
- Other construction costs
With a building loan, funds are disbursed in stages based on the progress of construction. An inspector will evaluate the work at different phases, and once each stage passes inspection, the lender releases the next round of funds
Building loans typically have variable interest rates, interest-only payments during construction, and terms of around 1 year or less. At the end of the construction period, the borrower must repay the full loan amount either with cash or by obtaining an end loan – essentially a traditional mortgage.
What is a Mortgage?
A mortgage is a long-term loan used to finance the purchase of an existing home. With a mortgage, you receive the full loan amount upfront at closing to cover the home purchase price and related fees.
Mortgages have fixed interest rates and longer repayment terms usually between 15-30 years. Your monthly mortgage payments cover both principal and interest. There is also collateral securing the loan in the form of the home you are purchasing.
Key Differences Between Building Loans and Mortgages
While both building loans and mortgages finance home ownership, there are some notable ways in which these two loan types differ:
Loan Term
- Building loans have short terms of around 1 year or less
- Mortgages have long terms of 15-30 years
Interest Rates
- Building loans have variable rates
- Mortgages have fixed rates
Payment Structure
- Building loans require interest-only payments during construction
- Mortgages require principal and interest payments
Collateral
- Building loans are not secured by collateral
- Mortgages are secured by the home being purchased
Loan Disbursement
- Building loans provide funds in stages based on construction progress
- Mortgages provide the full loan amount upfront
Repayment
- Building loans must be paid in full at the end of the term
- Mortgages are slowly paid down over the long repayment term
As you can see, the short-term, variable nature of building loans is very different from the structure of a long-term, fixed-rate mortgage.
When to Use a Building Loan vs Mortgage
So when should you opt for a building loan rather than a traditional mortgage? Here are the main scenarios:
Building a New Home
If you are constructing a brand new property, a building loan is the only option since the home does not yet exist. The funds will be used to cover construction costs until the home is move-in ready.
Major Renovations
You may need a building loan if you are doing major renovations like adding on an extension or gutting and rebuilding a property. The variable payments can accommodate the ebbs and flows of construction.
Purchasing Land
Building loans allow you to buy a vacant plot of land in order to build on it. You can use the funds for the land purchase and construction.
Want Variable Payments
The interest-only payments and adjustable rate of a building loan provide more flexibility, which some borrowers may prefer.
Limited Down Payment Funds
Building loans often only require 10-20% down, while mortgages typically need at least 20%. The lower down payment requirement makes building loans more accessible.
On the other hand, if you are buying an existing home that only needs minor renovations or is move-in ready, a traditional fixed-rate mortgage is likely the better option.
Building Loan vs Mortgage: Which is Right for You?
When deciding between a building loan or mortgage, there are a few key factors to consider:
-
Project – Are you building new or buying existing? What renovations are needed?
-
Budget – How much are construction costs or the purchase price? What are closing costs?
-
Timeline – How long until the home will be move-in ready? How long can you commit to a loan term?
-
Payments – Do you need flexible interest-only payments or can handle principal + interest?
-
Interest rates – Do you prefer a fixed or adjustable rate based on market conditions?
-
Down payment – How much can you pay upfront? What are the down payment requirements?
Carefully evaluating these elements will help you determine if a building loan or traditional mortgage better suits your home financing needs.
Getting Started with a Building Loan or Mortgage
Ready to move forward with financing your new home? Here are the first steps to get started:
Building Loan
- Research experienced construction lenders
- Find a qualified general contractor
- Provide construction plans, budget, and timeline
- Get preapproved based on finances and plans
Mortgage
- Check credit reports and scores
- Calculate budget and down payment amount
- Research mortgage lenders and get preapproved
- Make an offer when you find the right home
The preapproval process is key for both building loans and mortgages, as it will determine if you qualify and how much you can borrow. This will influence the size and scope of the home project you can take on.
Be sure to compare multiple lenders and loan offers. Look at interest rates, fees, loan terms, and eligibility requirements. Ask lenders plenty of questions so you understand the complete costs and process before committing.
The Bottom Line
When financing a home, building loans and mortgages each have their advantages based on your specific goals and financial situation. Building loans provide flexible short-term financing for construction projects, while mortgages offer fixed rates and predictable payments for buying existing homes.
Carefully weigh the differences in loan terms, interest rates, payments, collateral, disbursement, and repayment to decide which option best fits your home buying or building plans. With the right loan choice, you’ll be on your way to turning your dream home into a reality.
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- Construction loans are short-term loans that you can use to build a new home.
- Some construction loans can be converted to mortgages after your home is finished.
- Construction loans typically have tougher criteria than conventional mortgages for existing homes.
If you can’t find the right home to buy, you might be thinking about building a house instead. Financing this type of project is somewhat different than getting a mortgage to move into an existing property. Instead of a mortgage, you take on a construction loan (also known as a construction mortgage). Here’s what to know about construction loans.
What are construction loans?
Construction loans are loans that fund the building of a residential home (aka a stick-built house), from the land purchase to the finished structure. Common types are a standalone construction loan — a short-term loan (generally with a year-long term) — which only finances the building phase, and a construction-to-permanent loan, which converts into a mortgage once the construction is done. Borrowers who take out a standalone construction loan often get a separate mortgage to pay it off when the principal falls due.
You can use a construction loan to cover such costs as:
- The land
- Contractor labor
- Building materials
- Permits
The differences between Construction Loans and Long Term Mortgages
FAQ
What is the difference between a mortgage and a building loan?
Is it easier to get a loan to buy or build a house?
Is a construction loan a good idea?
What is the minimum FICO score for a construction loan?
Do you need a construction loan to build a house?
Building a house from scratch can be a great opportunity to get the home you’ve always wanted. But construction costs can add up quickly and timelines can be unpredictable. Luckily, a variety of construction loans provide the upfront cash needed to pay for the land, materials and labor to build a new house. What Is a Construction Loan?
What is the difference between a construction loan and a mortgage?
Beyond the cost and repayment timeline, construction loans and mortgages have a few main differences: The funds distribution: Unlike mortgages and personal loans that provide funds in a lump-sum payment, the lender pays out the money for a construction loan in stages as work on the new home progresses.
What is a construction mortgage?
A construction mortgage is a loan that pays for building a new home. During construction, most loans of this type are interest-only and will disburse money incrementally to the borrower as the building progresses. The two most popular types of construction mortgages are stand-alone construction and construction-to-permanent mortgages.
What are construction loans?
Here’s an explanation for Construction loans are short-term loans that you can use to build a new home. Some construction loans can be converted to mortgages after your home is finished. Construction loans typically have tougher criteria than conventional mortgages for existing homes.
Are construction loan rates higher than mortgage rates?
But in general, construction loan rates are typically around 1 percent higher than mortgage rates. With a construction loan, you typically don’t receive the full loan amount upfront. Instead, you receive the loan in installments to pay for the construction work in stages. Michael Gevurtz, CEO of Bluebird Companies, explains how this works:
Can a construction loan be converted to a mortgage?
Some construction loans can be converted to mortgages after your home is finished. Construction loans typically have tougher criteria than conventional mortgages for existing homes. If you can’t find the right home to buy, you might be thinking about building a house instead.