March 22, 1999
" 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
Construction can be financed in
two ways. One way is to use two loans, a construction loan for the period
of construction, followed by a permanent loan from another lender, which
pays off the construction loan. Two loans mean that you shop twice and
incur two sets of closing costs.
The second way is to use a single
combination loan, where the construction loan becomes permanent at the end
of the construction period. One loan means that you shop only once but you
must shop construction loans and permanent loans at the same time. The
single loan approach results in only one set of closing costs.
Some lenders (primarily commercial
banks) will only make construction loans. Others will only make
combination loans. And some will do it either way.
Construction loans usually run for
6 months to a year and carry an adjustable interest rate that resets
monthly or quarterly. 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".
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 credit
plus the one set of closing costs are major talking points of loan
officers pushing combination loans.
The rebate offered on combination
loans makes it difficult to compare these loans with the two-loan
alternative. For example, lender A offers a construction loan at 4 points
with 3 points applicable to a permanent loan, while B offers an untied
construction loan at 2 points. Going with A means saving one point on the
construction loan but this is no bargain if A's terms on permanent loans
are not competitive.
For example, suppose A offers a
permanent loan at 6% and 3 points, while lender C offers the same 6% loan
at 1 point. Then if you selected A, you would pay a total of 4 points on
both loans, but if you had selected B for the construction loan and C for
the permanent loan you would have paid only 3 points in total. A is above
the best price available in the permanent loan market by more than it is
below the best price available in the construction loan market.
Further, once you accept a
combination loan deal that involves a significant rebate from the
construction loan, shopping other lenders for a permanent mortgage after
construction ends is likely to prove fruitless. So long as the combination
lender is not above the market for permanent loans by more than the rebate
plus closing costs, you cannot do better by finishing the deal with
another lender. You're hooked!
This means that you cannot
properly assess a lender's combination loan without comparing that
lender's terms on permanent loans with those of other permanent lenders.
This is why you must shop construction loans and permanent loans at the
same time. If the combination lender is above the market on permanent
loans by an amount that is less than the saving on the construction loan
plus closing costs, you go with the combination loan. Otherwise, you go
with two loans.
An alternative is to ask
the builder to finance the construction for you. Then you have only
the permanent loan to worry about. This option is discussed in Should
the Builder Finance Construction?