A couple plans on constructing their retirement dream home but needs to know the best way to fund the project to avoid debt.

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Question: We own our home free and clear, and both have credit scores exceeding 800. We want to downsize and build a retiree-friendly custom home on land we own. We are debt-free, and the cost of building our new home will be less than the value of our present home. We then want to gradually move into our new home when it’s done. We will then put our current home up for sale and use the proceeds at closing to pay off the financing of our new home. Which is the best option for financing our new construction: a HELOC on our present home, a combination construction/permanent mortgage with one set of closing costs, or something else? Thanks. – Jim in West Virginia

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Denny from Lending Tree responds…

First of all, congratulations on the smart financial planning! It’s impressive to be free of debt (including your home) and have such excellent credit scores. I know you want to continue that smart decision-making as you build your next home. You didn’t mention your situation with savings, so I’m going to assume you don’t have bags of money lying around to fund your new home construction. You’re absolutely right to consider your financing options. Let’s take a closer look at the options you brought up and their potential repercussions.

Comparing 4 construction loan options

Home equity loans and lines of credit

Home equity loans

Home equity loans or lines of credit extend financing based on the equity in your home. For lenders to extend this financing, your home becomes collateral for the funding. A home equity loan would provide you a lump sum of money, which you’ll pay back over time at a fixed interest rate. The fixed interest rate offers stability, but if you run into unexpected construction costs, you can’t go back for more funds the way you potentially could with a home equity line of credit, or HELOC.

Home equity lines of credit (HELOCs)

A HELOC works more like a credit card, in that you’ll get a line of credit to use when you need it, for as much as you need (up to a predetermined limit). You’ll only make payments on the amount you borrow. During the draw period, you may be able to make interest-only payments, depending on the terms of your HELOC. Most HELOCs have variable interest rates, and each lender decides how often to increase the interest rate and how much the interest rate can change. Once the draw period ends after 10 years, you will begin to pay back principal plus interest. Your payments can significantly increase when this happens, so make sure you understand the terms of a HELOC before you use it.

Construction loans

A construction loan can be used to purchase the land for your new home and also build your new home. Typically, you’ll only make interest payments during the construction period, and the bank releases funding as needed to finance the project. The interest rates on construction loans are usually variable. You may need to provide a down payment of up to 25%, depending on the terms of the lender.

In your situation, you have two construction loan options:

Construction-to-permanent loans

With this type of loan, you’ll only have to pay closing costs and associated fees once. The downside is that, since the rate is locked in for a longer period, the rate may be higher than with a construction-only loan.

Construction-only loan

With a construction-only loan, you’ll get one loan to fund the construction. Once the construction company completes their work, you’ll take out another loan to pay off the construction loan. On the plus side, you can shop for a low mortgage rate on the second construction loan, and if there are unexpected construction costs, you may be able to take out some extra cash.

The downside is that you may have to take out a second loan at an interest rate and terms you won’t know until the construction is completed, unless you can time the sale of your current home to perfectly coincide with the completion of construction of the new home. Two loans mean two sets of closing costs and fees.

Finding the best option for you

I’m hesitant to recommend a home equity product for the simple reason that it puts your present home at risk. With your excellent credit and lack of debt, I would look at a construction-to-permanent loan. Since you’re planning to pay off the loan soon after construction, the higher interest rates won’t hurt (much). If you are worried about potential cost overruns, you could take out a HELOC before you apply for your construction loan so you can tap it if needed. You don’t want to be scrambling to apply for it at the same time you’re dealing with over-budget construction issues.

As with any loan, take the time to shop around and get rates from multiple lenders before you commit. Scrutinize the loan estimate carefully and ask the lender questions. Line up a high-quality builder, and you’ll be in the home of your retirement dreams before you know it!

Lending Tree are experts at mortgage refinance. Talk to them for your refi needs.

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About the Author

Denny Ceizyk

Denny Ceizyk

Denny Ceizyk is a staff writer at LendingTree and 25-year veteran of the mortgage industry. He has worked in all facets of home loans starting in loan processing and ultimately owning and operating a mortgage brokerage company for 18 years. Denny has written and presented to government housing, local media and national media about mortgage financial literacy. He graduated from the University of Arizona with a degree in Media Arts and Business, and recently relocated to New York City where he lives with his wife and daughter.

Published by Debt.com, LLC