Construction loans can offer financial support during the building process, but refinancing can provide long-term benefits. By refinancing a construction loan, homeowners can secure a lower interest rate for their permanent mortgage and potentially save money over time.
Refinancing also allows for adjustments to loan terms based on individual needs, such as switching from an adjustable to a fixed interest rate. Understanding the process and requirements of refinancing a construction loan is crucial when considering this financial option.
From experience of custom building two homes I’ve owned, construction loans are an excellent financing option. However, refinancing a building loan will be something you need to consider depending on the type of loan program you choose.
It is also essential to note that a land loan will be a better option if you don’t plan on building a home immediately.
If you’re in the process of building your dream home, chances are you took out a construction loan to finance it. Construction loans are short-term, high-interest loans designed specifically to fund building projects. But did you know you can refinance a construction loan once your home is complete?
Refinancing into a traditional mortgage can help you secure a lower interest rate and reduce your monthly payments. Here, we’ll walk through when and how to refinance a construction loan so you can save money on your new home.
What is a Construction Loan?
Before we dive into refinancing, let’s quickly review what a construction loan is A construction loan is a short-term financing option meant to cover the costs of building a new home These loans are structured differently than traditional mortgages in a few key ways
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Shorter term – Construction loans are designed to be paid back over a short period of time, usually around 1-2 years. This matches the typical construction timeline.
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Higher interest rate – Construction loans tend to have higher interest rates than mortgages, since they are considered riskier. Rates can range from 5-10%.
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Interest-only payments – During the construction phase, you only pay interest on the amount disbursed so far. You don’t pay down principal.
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Future financing required – Construction loans must be repaid in full or refinanced into permanent financing once the home is complete
The purpose of a construction loan is simply to finance the building of your home. Once construction is finished, you’ll need to switch to a regular mortgage. This is where refinancing comes in.
When Can You Refinance a Construction Loan?
The timing for refinancing a construction loan depends on what type of loan you have:
Construction-to-Permanent Loan
With a construction-to-permanent loan, you arrange both the construction financing and permanent mortgage upfront with the same lender. Once your home is complete, the loan automatically converts to a traditional mortgage based on the terms you already negotiated.
You can refinance as soon as construction is finished and you obtain the certificate of occupancy. There is no waiting period.
Construction-Only Loan
Construction-only loans are short-term loans that only cover the building phase. You need to qualify for permanent financing separately once construction is done.
Most lenders require you to wait 6-12 months after your home is completed to refinance a construction-only loan. This helps prove you can make the mortgage payments.
How to Refinance a Construction Loan
Refinancing a construction loan is similar to refinancing any mortgage. Here are the key steps:
1. Review your finances
Before applying to refinance, take a close look at your finances to ensure you’re in good financial standing:
- Check your credit score – scores of 700+ get the best rates
- Reduce other debt obligations if possible
- Maintain stable income during the building phase
This will help you qualify for the most favorable refinance terms.
2. Research current interest rates
Shop around and compare mortgage rates across multiple lenders. Rates fluctuate frequently, so be sure to check for the latest.
Online lender rate comparison tools can give you an idea of what rates you may qualify for based on your credit score, income, and other factors.
3. Calculate potential savings
Use a mortgage refinance calculator to estimate your new monthly payment and see how much you might save by refinancing. Small differences in interest rates can really add up over the life of a loan.
Also consider upfront refinancing costs like loan fees and closing costs. These are usually rolled into the new loan amount.
4. Apply to refinance
Once you find a favorable rate and lender, you can submit a mortgage application to refinance your construction loan. You’ll go through similar documentation and approval steps as you would with any mortgage.
This includes:
- Providing financial documents to prove income and assets
- Allowing the lender to appraise the new home
- Undergoing underwriting for approval
5. Close on your new mortgage
After approval, you’ll go through closing on your mortgage, finalizing the loan terms and paperwork. At this point, your construction loan is paid off and replaced with the new mortgage.
Make sure to closely compare the Closing Disclosure from both loans to understand all terms and costs.
Tips for Refinancing a Construction Loan
Follow these tips to make the most of refinancing your construction loan:
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Shop lenders – Compare loan offers from multiple lenders and negotiate for the best deal. Don’t automatically go with your construction lender.
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Monitor credit – Keep a close eye on your credit during the build so you’re ready to refinance at the best rates.
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Understand costs – Factor in loan fees and closing costs to see if refinancing makes sense for your situation.
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Lock your rate – Interest rates fluctuate constantly. Lock in your rate as soon as possible to secure your savings.
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Act fast – Try to refinance within 6-12 months of construction finishing to maximize potential savings over the life of the loan.
Alternatives to Refinancing
While refinancing is usually the best option, here are a couple other paths forward after your construction loan:
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Pay off the loan – If you have the cash, you can pay off your construction loan in full rather than refinancing to a mortgage. This avoids ongoing interest costs.
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Extend the loan – Some lenders may allow a short-term extension on a construction loan while you shop for permanent financing. Fees and conditions apply.
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Get a home equity loan – If your home value exceeds your construction loan balance, you may be able to take out a home equity loan for better rates.
The Bottom Line
Refinancing your construction loan into a traditional mortgage is the typical next step once your new home is complete. Be sure to explore multiple lenders to find the best interest rate and start saving on your monthly payments. With the right refinancing strategy, you can maximize savings and pay off your dream home ahead of schedule.
Construction Loan vs. Mortgage Loan: Key Differences
It’s important to differentiate between construction loans and traditional mortgage loans. At the same time, mortgage loans purchase already-built homes, and construction loans finance building or renovating properties. Construction loans often have higher interest rates and shorter terms than mortgage loans.
Additionally, mortgage loans require a larger down payment, typically around 20% of the home’s value, while construction loans may require a smaller down payment during construction.
The Draw Schedule: How Funds are Disbursed
A crucial aspect of construction loans is the draw schedule, which determines how and when funds are disbursed during the construction process. Lenders often conduct inspections at different stages of construction to ensure that the work is progressing as planned.
As each phase is completed, the lender releases a portion of the funds, known as a draw. Builders or contractors can then access these funds to cover material costs, labor, and other expenses related to the construction project.
Whether you are building a cheap house or a mansion, the lender wants to have a disbursement schedule.
Use A Construction Loan To Build A House?
FAQ
How long after building can you refinance?
Can you convert a construction loan into a mortgage?
Can you refinance during the build?
What is the primary disadvantage of a construction permanent loan?
Should you refinance a construction loan?
Refinancing your construction loan is a great strategy to get a lower interest rate on your end loan. Shop around for mortgage rates during the final phases of construction so you’re ready to refinance when the final nail has been hammered and the last screw has been tightened.
Can you get a construction loan for a new home?
Construction loans exist to finance new home construction. Homeowners who want to renovate an existing home have other options, including: Home equity loans: These “second” mortgages tap your current home’s value so you can use it on renovation projects.
What is a construction loan?
A construction loan is a short-term loan that covers only the costs of custom home building. This is different from a mortgage, and it’s considered specialty financing. Once the home is built, the prospective occupant must apply for a mortgage to pay for the completed home.
Can a borrower refinance a construction-to-permanent loan?
No. The borrower must meet the cash-out refinance construction-to-permanent financing eligibility since they are receiving funds back for the cost overruns. Q14.