Construction Loan Vs. Home Equity Loan

Construction Loan Vs. Home Equity Loan

Home equity loans and construction loans are two types of loans which are secured by real estate which makes them a bit similar to each other. To know more, read on.
WealthHow Staff
As mentioned above, the construction loan and the home equity loans, are both similar and also dissimilar with respect to several of their features and also their mechanism. The significant difference in the construction loan and a home equity loan is that construction loan is granted for the actual construction of the house, however the home equity loan is granted against the collateral of the home's equity. Here's explanation to each of the loans and the differences between them...

Construction Loans

Construction loans are tailored according to the needs and specifications of the construction project, which has led to the connotation that construction loans are story loans. The following are some of the important characteristics of the construction loan:
  • The principal amount of the loan is not equal to the total cost of construction, it's usually a bit lower by 2-8% and in some cases, even lower. The total principal amount is used through the time period to aid the construction expenses of the borrower.
  • Since the construction process is planned and scheduled, the borrower, lender and the contractor workout a schedule of 'draws'. Draws are principally structured payments in the form of multiple installments to the borrower and the contractor, in accordance in which the construction expenses are deemed or scheduled to be insured.
  • The repayment of the loan is made over time along with the interest. Here is where we come up to part of interest payment, which is a bit different in comparison to the remaining real estate related loans. The interest can be levied by the lender in two different manners, namely, fixed and variable rates.
  • The fixed rate of interest is of course, charged from the date of first draw to the date of last installment. This kind of interest charged often ends to be quite reasonable and by the virtue of cost, cheap.
  • The variable rate of interest on the other hand is charged quite differently. Such a rate of interest is calculated on the basis of certain specified indexes such as the interest index of the central banks. The interest is conventionally charged on every draw and is paid in the repayment phase. In such case the first few installments are just for the payment of interest of the loan.
  • The real estate and the partial equity of land (in some cases) is pledged as a collateral for the security of the loan.
If you are planning on taking up a construction loan, then it would be wiser to go in for a loan which is granted by a prominent bank or a financial institute that specializes in construction loans. This will enable you to take up the advantage of a lower interest rate. Apart from that, given an option, it would be favorable to go in for a fixed interest rate and reasonable 'draws', as they will considerably make the cost of entire project well priced and not obnoxious. Let's move on to the other side of the 'construction loan vs. home equity loan' debate.

Home Equity Loans

The vast difference in the construction and home equity loans is that a construction loan is principally used to build a home. However, the home equity loan on the other hand is a loan that is given against the equity value of a (completed and finished) house. The important characteristics of the home equity loan go as follows:
  • The home equity loan is chiefly granted for the collateral of home equity of your house. Now the home equity is calculated by deducting the equity amount that has been pledged as a collateral for another loan such as a mortgage loan or a construction loan.
  • For example, your initial mortgage may amount to $400,000, and your home after 5 years of purchase may amount to about $480,000. In such circumstances, you can apply for a home equity loan of about $70,000.
  • Home equity loans have a fixed rate of interest and the repayment of the loan is in the form of a fixed set of installments which have a fixed rate of interest integrated into them. Interest rates of home equity loans are often derived by adding premium rates and a margin which makes them a bit costlier than compared to mortgages.
  • The collateral of the equity is often known as a second lien, which means that in case of a certain default, the lender can initiate either of 3 processes. Initiate a foreclosure, in collaboration with the other loan's lender. Secondly, the lender can liquidate the equity by selling it or pledging it with other financial institutes or selling it to the other lender. Thirdly, the lender can simply wait of bankruptcy proceedings or a short sale.
  • A merit of the home equity loans is that such loans are personal loans which can be taken or borrowed for any possible purposes, unlike construction loans which are lent for the purpose of construction.
A cost wise comparison always depicts that a home equity loan is cheaper than the construction loan as the interest rate is lesser, owing to it being of fixed form. However, the cost element often differs from case to case as the cost of construction and the equity value of the loan do differ.