Creating a new home is an exciting accomplishment in life. For those home buyers, the One-Time Close Construction Loan is the perfect loan that combines a construction loan with a permanent loan making the decision to build a custom home more affordable as you are both financing your lot and your house all in one. This type of loan streamlines the process, cuts down on closing costs and offers certainty from start to finish in the home construction process.
But the way that borrowers perceive and feel them is being reshaped by one key element in today’s economy: inflation. When inflation surges, it affects everything from the price of building materials to the interest rates that lenders charge. It is important for anyone who is looking to take out a One-Time Close Construction Loan so they will have that in mind.
We’ll take a closer look at what rising inflation means for loan rates and how that affects borrowers, as well as other strategies for navigating the tough conditions created by inflation in the housing market.
What Is a One-Time Close Construction Loan?
Before we get into inflation, let’s revisit what sets a One-Time Close Construction Loan apart.
Historically, building a house typically required two loans:
- Construction Loan – Short-term financing to cover the cost of building.
- Permanent Mortgage – A separate loan to pay off the construction loan once the home is complete.
Instead, you would break the two parts into (1) a construction loan and (2) a mortgage. With a One-Time Close Construction Loan both the construction interest payments during construction and the down payment are all paid at once prior to the start of construction. That means that rather than officially close twice, lock in your interest rate up front and pay duplicate closing costs. The following is a list of these loans, as well as the programs in which they are offered:
- FHA One-Time Close Construction Loan – Insured by the Federal Housing Administration, ideal for consumers with less than perfect credit.
- Conventional One-Time Close Construction Loan – Fannie Mae or Freddie Mac backed for applicants with good to excellent credit.
- VA One-Time Close Construction Loan – Ideal for veterans and active-duty service members with no down payment required.
It’s simple, predictable and cheaper,” he said of the benefit. But inflation can undermine the benefits of this approach by impacting the loan rates pegged to the program.
Understanding Inflation and Its Role in Lending
Inflation is the pace at which the general level of prices for goods and services goes up, eroding purchasing power. When inflation increases:
- The price of goods such as lumber, steel and concrete has risen, pushing up construction budgets.
- Mortgage and construction loan rates are fluctuating in response to the economy.
- Loans don’t get more expensive just because the Fed raises interest rates, but borrowers feel it in the pace at which they pay their loans off.
The centerpiece here is the Federal Reserve. The Fed tends to raise the rate in high-inflation environments in an effort to cool the economy. Mortgage lenders, for their part, raise interest rates because they have to pay more to borrow themselves. And, because One-Time Close Construction Loan rates are implied to be associated with average mortgage rates (Which means, when demand for these types of products is low or the housing market just isn’t performing well, much like other marketplace lenders they can experience sudden shifts in pricing.
How Inflation Impacts One-Time Close Construction Loan Rates
1. Higher Borrowing Costs
When inflation rises, lenders face increased uncertainty. They raise rates to protect their returns against the devaluation of money over time. For homebuyers, this means that the once “locked-in” rate of a One-Time Close Construction Loan may be significantly higher than during periods of low inflation.
2. Increased Demand for Rate Locks
A notable benefit of a One-Time Close loan is that you may be able to lock in your interest rate before construction even starts. That feature is worth more during inflationary times, when future rate hikes may make more traditional two-loan approaches riskier and costly.
3. Strain on Affordability
When loan rates are higher, monthly mortgage payments will be higher. With inflation adding to the cost of construction, that makes them unaffordable for many families. One percent more in mortgage rate, for example, could raise the cost of a new loan by hundreds of dollars per month.
4. Tighter Lending Standards
Lenders tend to get more cautious during times of inflation. Because One-Time Close Construction Loans are already heavily scrutinized, borrowers may see stiffer credit score or debt to income (DTI) pressure as the lender tries to minimize risk.
5. Impact on Home Equity Growth
Inflation is a two-edged sword. On the other, it costs you more money. On the other, it can push up property values. To the contrary, homeowners who arranged a One-Time Close Construction Loan during periods of inflation may find their new home appreciating at a faster rate. But that doesn’t exactly make up for the near-term sound of higher rates and payments.
Example: Inflation’s Effect on Loan Payments
We’ll illustrate with a hypothetical borrower purchasing a One-Time Close Construction Loan of $400,000:
- At 4% interest rate: Monthly payment = ~$1,910
- At 6% interest rate: Monthly payment = ~$2,398
That’s close to a $500 additional payment per month that is purely due to rising interest rates and inflation. This gap is in many cases what separates a loan from being affordable and too costly.
Inflation’s Ripple Effect on Construction Costs
Loan rates aren’t the only worry. Inflation also affects the construction process:
- When wages go up, labor costs increase.
- Prices rise for building materials like lumber, drywall and roofing.
- Everything from transportation to production is affected by energy costs.
- Supply chain disruptions elongate lead times and drive up carrying costs.
Because a One-Time Close Construction Loan secures financing in advance, borrowers could find their construction budget overstretched halfway through the project if inflation inflates costs. This is why it’s absolutely essential to plan carefully, and work with experienced builders and lenders.
Strategies to Navigate Inflation When Using a One-Time Close Loan
1. Lock in Rates Early
And seeing as how these loans allow you to guarantee your rate before construction starts, consider using that protection when inflation is on the rise. The sooner that you lock in a rate, the less likely you are to experience further increases.
2. Choose the Right Loan Program
- Veterans may find the VA One-Time Close Construction Loan less oppressive, since there’s no down payment required.
- Borrowers with less-than-stellar credit may find the FHA One-Time Close Construction Loan appealing because you can have people who not-so-great credit scores participate in the program.
- Borrowers with the strongest credit scores may find more favorable terms of a Conventional One-Time Close Construction Loan.
Choosing appropriate program based on your financial position are critical for reducing the effect from inflation.
3. Budget for Rising Costs
Collaborate with your builder to preempt potential increases in material or labor costs. Structure a cushion in your construction budget so inflation does not derailed your project.
4. Consider Shorter Loan Terms
Although 30-year mortgages are popular, looking into 15-year terms may allow you to lock in lower rates. The payments will be larger but you could end paying far less in interest over time.
5. Stay Informed About Economic Trends
Because inflation can ebb and flow, so does mortality rate You’ll want to stay abreast of Federal Reserve decisions and housing market trends as you determine when to apply for your loan.
Long-Term Perspective: Is Inflation Always Bad?
Although inflation poses immediate problems, it’s not entirely bad news for homeowners. As a historical pattern, real estate appreciates more quickly than the rate of inflation over time. That is, while you may be paying a high interest rate now, your home could appreciate and end up providing financial security and equity in the future.
Also, after your One-Time Close Construction Loan converts to a permanent mortgage, you may have the opportunity to refinance if interest rates are favorable in the future. Borrowers generally do this to decrease their payments once times of high inflation come to an end.
Conclusion
One-Time Close Construction Loan rates get influenced greatly by inflation default state (goal to be 2% annually). Borrowing costs are higher, lending standards are tighter and construction costs are increasing for borrowers in the current market. Still, with some smart planning including locking in rates early, special budgeting and choosing a loan program that’s right for you building your own pad is still very possible.
The key is to understand how inflation drives the housing and lending markets. In doing so, you can not only get ready for the obstacles to homeownership you face today but also set yourself up for long-term success as a homeowner.
The One-Time Close Construction Loan is still a sterling product in any interest rate environment. With a great lender and some strategy, you can move past the cost increases and build the home you’ve always wanted.