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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.
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