3 Reasons You'll End Up Paying More for a Construction Loan

by Dana George | Updated July 19, 2021 - First published on April 17, 2021

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Two construction workers looking at plans on a table in a house being built.

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Planning ahead makes it possible to save money when building a home.

If you've fantasized about building a home of your own, you may be surprised to learn that construction loans are more expensive than residential loans. We look at three reasons why, and discuss how to keep more money in your bank account.

1. Land cost

When you're building your own home, you get to decide where you want that home to be. Do you want land in the country? Or do you see yourself in a neighborhood near the city center? Do you plan to shop around for land and pay it off before you begin construction? Or find a lot and roll the price into your loan?

Here are two ways purchasing land before financing construction can pay off:

  1. You're less likely to overpay for a lot, because you're not under pressure to find one.
  2. You can use equity in the building site as your down payment or partial down payment.

How to save: If you plan to finance land (or a building lot) as part of the construction loan and roll it into your mortgage, shop carefully for the best place to build. You are far less likely to overspend if you're not in a hurry to find a spot to call home. Let's say you find a great lot in a nice area for $50,000. If you roll it into a 30-year mortgage at 3.5%, you pay a total of $80,828 for the lot ($50,000 + $30,828 in interest). Now, imagine you're in a hurry to find a place to build, so you buy a similar lot for $60,000. After 30 years, you pay a total of $86,994, including $36,994 in interest.

2. Architectural plan

The mortgage lender requires that you have house plans ready, so if your builder doesn't already have them, someone must draw them up before you apply for a loan. For that service, most architectural firms charge between 5% and 20% of the cost of the house, an average of $15,000 to $60,000 for a 2,700-square-foot home, according to HomeAdvisor. Fees paid to an architect are considered a "soft cost" and may be rolled into a construction loan. Because design fees are not an expense you face when purchasing an existing home, it pays to consider ways to save money.

How to save: Consider pre-designed home plans. They're available in every style and size under the sun, and most companies will customize them for an extra fee. Pre-designed plans for a 2,700 square-foot home start at around $1,000.

3. Short-term construction loan

Not long ago, your only option was to take out a short-term construction loan, and once the house was complete, take out a traditional mortgage. That's two loan processes -- and two sets of closing costs. You still find lenders promoting this payment method, and borrowers don't always know there are other options.

Because construction loans are designed to be short term (typically less than one year), the interest rate is variable, and fluctuates with the prime rate. Due to the risks involved in financing a home build, the interest rate is usually higher than the current mortgage rate. Depending on what's happening with the prime rate -- the interest rate at which banks loan money to other banks -- you could pay a pretty penny for a construction loan.

How to save: Rather than take out a short-term construction loan followed by a mortgage, take out a single construction-to-permanent mortgage (also known as a "single-close"). As long as you lock in a mortgage with a fixed-rate loan, you know precisely how much your loan will cost, and don't need to worry about fluctuating rates.

Building a home is exciting, but can be stressful. Advance planning can you help save money -- and a fair number of headaches. That way, you're free to focus on creating the home of your dreams.

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