When considering a new construction project, one of the most important decisions is how to finance it. Two common financing options are construction loans and mortgages.
While each option has advantages and disadvantages, one question frequently arises: Which is cheaper?
Construction loans vs mortgage loans
Construction loans are designed to provide short-term financing for the construction phase of a project.
As construction develops, the borrower receives funding and pays interest only on the amount drawn. After the completion of construction, the loan is refinanced into a traditional mortgage.
A mortgage is a long-term loan used to buy or refinance a property. Mortgages offer lower interest rates and longer repayment durations than construction loans.
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Is a construction loan cheaper than a mortgage?
Construction loans and mortgages are two different types of loans, and the cost of each loan depends on the lender, loan conditions, and borrower circumstances.
Because construction loans are riskier for lenders and charge interest on funds as they are drawn down, they may have higher interest rates than standard mortgage loans.
However, the interest rate on a construction loan usually is just during the construction phase; once the construction is completed and the property is evaluated for value, the loan will usually convert to a standard mortgage loan with a market-based interest rate.
Mortgages are long-term loans with variable or fixed interest rates depending on market conditions and lender rules.
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Is it harder to get a construction loan than a mortgage?
Construction loans are riskier for lenders than mortgage loans, making them harder to get. The lender is funding a property that has yet to be developed; therefore, its worth is unknown.
To approve a construction loan, the lender will typically require detailed plans and specifications for the construction project, as well as a detailed budget and a schedule for the completion of the project.
Lenders also look for borrowers’ experience in construction and their credit history. After construction, borrowers refinance short-term construction loans into long-term mortgage loans. This might complicate and endanger the financing.
Traditional mortgage loans depend on the property’s valuation and the borrower’s creditworthiness and capacity to repay. This process is relatively simple if the borrower satisfies lender requirements.
Overall, construction loans are harder to get than mortgage loans, but they’re not impossible.
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