March 22, 1999, Revised December 27, 2006
" My wife and I are considering having a house built for us and I would like to know the basics of combination construction/permanent mortgages. What do we look out for?"
Alternative Ways to Finance Home Construction
A newly constructed home can be financed in three ways.
- The builder finances construction, and when the house is completed the buyer obtains a permanent mortgage.
- The buyer obtains a construction loan for the period of construction, followed by a permanent loan from another lender, which pays off the construction loan.
- The buyer obtains a single combination loan, where the construction loan becomes permanent at the end of the construction period.
This is the simplest approach with important advantages to the buyer, including not having to worry about the builder's financial capacity, or the complexities involved in the alternatives discussed below. It is discussed in Should the Builder Finance Construction?
Separate Construction Loans and Permanent Mortgages
The obvious downside of two loans is that the buyer shops twice, for very different instruments, and incurs two sets of closing costs.
Construction loans usually run for 6 months to a year and carry an adjustable interest rate that resets monthly or quarterly. The margin will be well above that on a permanent ARM. In addition to points and closing costs, lenders charge a construction fee to cover their costs in administering the loan. (Construction lenders pay out the loan in stages and must monitor the progress of construction). In shopping construction loans, one must take account of all of these dimensions of the "price".
Some lenders (primarily commercial banks) will only make construction loans. Others will only make combination loans. And some will do it either way.
Note: Interest on construction loans is deductible as soon as construction begins, for a period up to 24 months, provided that at the end of the period you occupy the house as your residence.
The permanent loan is no different from that required by the purchaser of an existing house, or by the buyer of a new house on which the builder financed construction. Indeed, the advantage of the two-loan approach relative to the combination loan discussed below, is that the buyer retains freedom of action to shop for the best terms available on the permanent mortgage.
Combination Construction/Permanent Mortgages
The major talking point of the combination loan is that the buyer only has to shop once, and has to pay only one set of closing costs. The danger, however, is that the buyer will overpay for the permanent mortgage because the arrangement has limited his options.
Lenders offering combination loans typically will credit some of the fees paid for the construction loan toward the permanent loan. The lender might charge 4 points for the construction loan, for example, but apply 3 of the points toward the permanent loan. If the borrower takes the permanent loan from another lender, however, the construction lender retains the 3 points. This makes it difficult to compare combination loans with the two-loan alternative.
For example, suppose the buyer wants to compare the cost of the construction loan offered by the combination lender cited above with an independent construction loan offer at the same rate plus 2 points. The buyer can get the construction loan for 1 point provided he also takes the permanent loan, or for 2 points while retaining his freedom of action to shop for the best deal on a permanent loan. Which is the better deal depends on how the combination lender prices the permanent loan relative to the competition.
This is not easy to determine. While you can compare current price quotes on permanent loans by the combination lender with quotes from other lenders, these don't mean much. The actual price won't be set until after the house is built, and at that point the combination lender has an incentive to over-charge. In my example, he can over-charge by up to 3 points, because that is the amount he retains if the buyer goes elsewhere.
The upshot is that I would not take a combination loan unless a) the current combination price quote was at least as good as the best quotes from separate construction and permanent loan lenders; and b) the combination lender was willing to index the price of the permanent loan so that I knew exactly how it would be set when the time came.
If the combination lender insists that you will get the market price, it is time to bail out and go with two loans.