Everything You Need To Know About Closing Costs on Construction Loans

Getting a construction loan to build your dream home can be an exciting prospect. But before you get too carried away with plans for granite countertops and open concept living, it’s important to have a clear understanding of the closing costs involved with construction loans. These fees and expenses can really add up, so being prepared and budgeting properly is key.

In this comprehensive guide, we’ll walk through all the nitty-gritty details surrounding closing costs on construction loans. Whether this is your first time building a home or you’re a seasoned pro, you’re sure to learn some helpful tips and information

What are closing costs?

Closing costs are essentially the fees charged to finalize and “close” on a loan. They cover all the administrative costs taxes and other expenses required by the lender to fund the loan.

On a construction loan, closing costs are typically higher compared to a traditional mortgage for an existing home. This is because construction loans are seen as higher-risk for lenders, so they charge more in origination fees and other costs to offset that risk.

Closing costs are generally between 2-5% of the total construction loan amount. So for example, if you get approved for a $300,000 construction loan, you can expect to pay $6,000 – $15,000 in closing costs.

Now let’s take a closer look at some of the common fees included in closing costs on construction loans:

Itemized Closing Costs

Here are some of the major fees and expenses that are typically included in closing costs for construction loans:

• Origination fee – This covers the lender’s costs for processing, underwriting, and approving the loan. Usually 1-2% of the loan amount.

• Appraisal fee – Pays for a professional appraisal of the land/property. Typically $300 – $500.

• Credit report fee – Covers the cost of the lender pulling your credit report. Usually $50 – $70.

• Title fees – Pay for title insurance, title search, document prep fees, notary fees, etc. Often $1,000 – $2,000.

• Recording fees – Charged by the local government to record property titles and loan documents. Varies by location but often a few hundred dollars.

• Inspection fees – Covers required inspections by the lender during different phases of construction. Plan for $200 – $500 per inspection.

• Taxes – Certain state and local taxes charged on mortgages. Depends on location.

• Interest reserves – Money set aside to pay interest during the construction phase, when only interest payments are made.

• Permits & fees – Building permits, impact fees, utility hookup charges. Varies widely.

• Attorney fees – If you hire a real estate attorney to review documents. Typically $500 – $1,500.

As you can see, closing costs can really add up. It’s not uncommon for total closing costs on a construction loan to reach $15,000 – $20,000.

Strategies for Reducing Closing Costs

The good news is, there are some things you can do to minimize closing costs on your construction loan:

• Shop around – Get quotes from multiple lenders and negotiate to reduce origination fees. Even a 0.25% difference in origination fees can save you big.

• Get credits – Ask the lender if they offer any lender credits to help offset costs. Just keep in mind credits usually require a higher interest rate.

• Pay discount points – Paying “points” upfront can lower your interest rate, saving more over the life of the loan. Each point is equal to 1% of the loan amount.

• Lower loan amount – Don’t borrow more than you absolutely need for the project. The lower the loan amount, the lower the overall fees.

• Don’t finance permits/fees – Pay for permits, impact fees, and hookup charges in cash if possible rather than financing them.

• Comparison shop title fees – Title insurance and related title fees can vary widely between companies.

• Watch inspector costs – Don’t overpay for inspections. See if family/friends with construction experience can help.

With some savvy negotiating and cost comparisons, it’s possible to reduce your total closing costs by a few thousand dollars in most cases.

Closing Costs and Loan Disbursements

Most lenders will structure construction loan disbursements to help minimize the cash needed upfront for closing costs and project startup expenses.

Here are two common ways lenders handle the initial disbursements:

Lump sum – The first disbursement is one large lump sum, a portion of which covers closing costs. For example, on a $300,000 loan, the first disbursement may be $100,000, with $20,000 going to closing costs and $80,000 available for construction.

Two separate disbursements – The lender issues two separate disbursements at the beginning – one to cover closing costs and one to start construction. For example, they may disburse $20,000 for closing costs and $80,000 for construction startup. This approach requires less cash upfront from the borrower.

Talk with your lender ahead of time to understand how they handle initial disbursements so you can properly budget the cash you’ll need. Some lenders may even allow you to finance 100% or more of closing costs and fees by rolling them into the loan amount.

Should You Pay Closing Costs Out-of-Pocket?

Since closing costs on construction loans can be so high, borrowers often wonder if they should pay some fees out-of-pocket rather than financing everything. Here are some pros and cons to consider:

Pros of Paying Out-of-Pocket

• Lower loan amount and overall interest charges
• May allow bigger loan approval if you have limited assets/income
• Less cash needed later for the permanent mortgage

Cons of Paying Out-of-Pocket

• Requires more cash upfront
• Results in higher monthly payments on the permanent mortgage
• May limit funds available during construction

There’s no definitive right or wrong approach here. Paying some closing costs in cash upfront can save money long-term, but may also strain your budget in the short term.

A good compromise can be paying “prepaids” like property taxes, insurance, permits, etc. in cash, while financing heavier costs like origination fees. This lightens the burden during construction.

Closing Costs on Construction-to-Perm Loans

For construction loans that convert to permanent mortgages (“construction-to-perm”), you’ll essentially pay closing costs twice – once on the construction loan and again when you obtain the permanent mortgage after completion.

On the bright side, some costs like title fees and appraisals can be applied to both closings. And you may be able to negotiate a lender credit from the permanent lender to offset repeat fees.

Just be aware that your total costs will be higher with a construction-to-permanent loan versus financing with a single construction lender for the duration of the project. Some choose to use separate lenders to get the best rates, while others opt for simplicity by using the same lender.

Are Closing Costs Tax Deductible?

Here’s some good tax-related news – many of your closing costs and loan fees can qualify as tax deductions, including:

• Origination fees/points
• Appraisal and credit report fees
• Title insurance premiums
• Recording fees
• Surveys

To claim deductions, you’ll need to itemize on your federal tax return. Talk with your tax professional to determine which costs are deductible. With thousands in potential deductions, this can lead to some nice tax savings.

The Bottom Line

Closing costs are a reality you can’t avoid with construction loans, but going in with clear expectations helps. Now that you know the major fees involved, you can budget wisely and shop around for the best loan rates and terms. Look for a lender that provides transparency and choices in how closing costs can be structured.

While the upfront costs might make you cringe a bit, just keep your eye on the prize – those dream home plans that will soon be a reality! With proper planning and budgeting, you’ll get through closing and be turning dirt in no time. Here’s to happy construction ahead!