Traditional Mortgage versus Construction Loan

Owning a house should be easy. After all, you have the resources needed and the manpower required to build your dream home.

But you still have one hurdle to jump over: mortgage type.

In this blog, we will briefly introduce you to the two major types of mortgages available for you and how these come into play with your housing project.

We promise not to make this too technical. In fact, we will do this by presenting them in the simplest manner possible for you to fully understand them.

Let us jump in then….

Traditional Mortgage

By now you have already been made familiar with the different mortgage offers available at your disposal such as housing loan, 2nd mortgage loan, FHA loan, etc.

Traditional mortgage – also known as conventional loans – is defined as an agreement that is not backed up (neither guaranteed nor insured) by the government. In addition to this, a traditional loan is equivocally referred to as “conforming loan/mortgage” which means this deal meets the requisites in order to be “sold” to either Fannie May or Freddie Mac.

(NOTE: Fannie May and/or Freddie Mac are government-sponsored companies and will be discussed in further detail on our succeeding blogs.)

Traditional Mortgage Requisites:

To summarize everything, these are the requirements that make up a traditional or conventional loan/mortgage:

a. Down payment – this is your first step in acquiring a traditional mortgage. Regardless of your status – new house builder or new home buyer – you will have to pay an initial amount that would guarantee your stake in owning or buying a property. Down payments can dip as low as 3% or can jump as high as 40% depending on your financial capacity. It is not a necessity to give a down payment; however, if you are planning to extend your mortgage loan then paying this amount will be an advantage to you.

b. Interest rate – this is related to the first requisite and is self-explanatory. One important thing to remember is that interest rate(s) is/are not fixed and always change on a daily basis.

c. Private mortgage insurance – this forms part of your mortgage agreement and you have to settle this per stipulation on your contract. This is needed to ensure that your mortgage loan is secured: if you fail to pay your amortization on time then the insurance will shoulder your past due amount. We suggest speaking to your mortgage advisor regarding this before signing your contract.

d. Credit score – this is a MUST-HAVE for every mortgage commitment. You should have, at the very least, 620 credit points to make you eligible to apply for a traditional loan.

e. Debt-to-income ratio – this is another MUST-HAVE that you have to make certain this appears between GOOD and EXEMPLARY to your lenders. This represents a figure that corresponds to the amount of your income that will be assigned to pay off your outstanding obligation. In other words, the DIR tells lenders how much you are willing to stave off from your monthly income in order to settle your debts without compromising your normal existence.

f. Loan size – this requirement is a variable unit. Your loan size is dependent upon Fannie May or Freddie Mac’s limitations. We suggest that you consult the FHFA (Federal Housing Finance Agency) website for more information.

Conventional Loan Variances:

In addition to the above-mentioned requisites, there are also variances present in the traditional mortgage or conventional loan that is often not found in the most common types of loans.

They are considered as special conventional loan types and are as follows:

a. VA loans – these loans are only for veterans and active-duty military personnel. Surviving spouses of deceased military members are also considered for this type of loan. Advantages of this loan type are (1) they do not require any down payment and (2) they do not require any mortgage insurance payment regardless of how much you pay initially.

b. FHA loans – these loans are backed by the Federal Housing Administration and are stricter in enforcing credit requirements. Advantages of this loan type are (1) immediate credit approval with a low credit score of 520 points and (2) minimum down payment is pegged at 3.5% only.

c. USDA loans – these loans are quite limited in their scope. They are only used in buying properties in qualifying rural areas (provincial-based properties) and not in urban areas (city-based properties).

There are two caveats with USDA loans, though, and they are (1) income limits that vary on city and state where the house is purchased and (2) the lender(s) will consider EVERYONE on the loan and not just the BORROWERS on the contract.

(NOTE: The second caveat requires vouching for the entire household income before loan approval is granted.)

Construction Loan

Construction loan offers higher rates and shorter-term agreements. Moreover, this type of loan is based on the projected value of the house once it is completely against a traditional loan that is based on the fair market value of the property.

To help you more with your construction loan, we suggest that you find a construction loan broker beforehand.

Under this major type of loan, you will find three sub-major types that you can avail:

a. construction-to-permanent loans – these loans fit you if your construction plans are definite and your timelines are properly defined. The bank (lender) pays the builder (contractor) while the house build is in progress.

b. Construction-only loans – these loans require full payment once the house build project is finished or ended. One caveat to these loans is that you must have a huge amount of money in the bank to cover your payment. Otherwise, you have to find a lender who will provide you with a 2nd mortgage for additional funding.

c. Renovation construction loans – these loans are best for you if purchasing a fixer-upper or a property that needs renovation. Pre-built homes for sale qualify for this loan type provided that there are renovations needed to repair the property.

(NOTE: These loans can also be considered as a project loan for builders since they focus on construction ONLY and are not applicable to any endeavor.)

Benefits and Non-benefits of a Construction Loan

Certain benefits accompany a construction loan and they are as follows:

a. They are considered interest-only during construction – banks will not seek payment just yet until the construction is finished.

b. They have flexible terms – construction loans have more flexible terms compared to conventional loans simply because of the nature of the former. You can play around with the terms as long as it does not cause any breach between lender and borrower.

c. Added scrutiny provides security – this benefit is an intangible one since it carries no actual value. What this does is that it ensures that your entire project remains on schedule and sticks to its projected budget.

Conversely, there are also disadvantages to a construction loan and they are the following:

a. They are harder to qualify for – construction loans have higher qualifying standards regarding credit and down payment. Banks normally come up with specific terms and conditions regarding this loan type.

b. They have a higher interest rate – their flexibility comes with a corresponding effect on the interest rate: banks can assign a higher-value interest to their clients. In simplest terms, the variable amount of interest is directly proportional to (or computed in alignment with) the prime rate is given.

c. They are risky because of their short-term nature – these loans need to be fully paid once the construction is finished. If your lack funds then we suggest that you speak to a construction loan broker first before committing to this loan type.

To summarize everything, a construction loan opens an opportunity for any housebuilder every possible means to determine when to borrow money for new house construction or to plan on how to get money for renovations when buying a house.

Final Thoughts

Two major types of loans exist traditional loans and construction loans. The traditional loan covers almost every type of project you have in mind to fund them such as insurance loans, credit loans, housing loans, etc.

Construction loan, on the other hand, is primarily for building a house; thus, this loan is often considered a “house builders’ loan” because of its special features that differentiate it from most conventional loans.

It is compulsory to seek the advice of a professional construction loan broker so that you will be better informed on how this agreement plays out and whether you really need this or you do not. Never speculate on what type of loan to apply for because this will be disastrous for you in the long run.

Be wise in your decision and you can be assured of security – both financially and emotionally – once your dream house has been fully financed and finally completed.

We are a trusted financial company that has helped 96 clients materialize their dream homes in Canada. Our vision is to help families build, develop, and/or improve their homes for them to live conveniently and comfortably.
Call 416-825-0142 or email today to learn more.

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