I had to read this a couple times to make sure I understood it. I still might be a little confused but here is my best shot at a response.

Basically your talking about an additional $50,000 on the loan. That translates into roughly an extra $350.00 per month on the final loan. That is a substantial amount of money, to me, and I don't think I would want that possibility hanging over my head. The 5% earnings in savings would not affect my decision because our house and the amount we financed is based on what our *work* income can afford. We did not include *investment* income when we figured out our desired monthly pay't.

About this statement....

"After the conversion from construction to permanent loan, we can make a prepayment to reduce the loan balance and monthly payments."

Be careful with this. This sounds an awful lot like a re-finance which comes with a whole new set of fees and closing cost.

If you need a mortgage, I'd go with the bigger loan, if you qualify. And keep it.

Having liquid assets is always better than having a lot of home equity, which is not easily accessible.

I'd either have as little equity as possible or own the house without a mortgage.

Because if you owe the bank even only $1 and you can't pay that, they will be able to foreclose and ruin your nice equity.

Let's see if I can explain a little better. We were planning to get a 200K mortgage. I think we could qualify for 300K and am considering doing that. Because it would protect more of our cash during the build(from a builder disaster; the bank's insurance company would go after the builder first, us second). It would also preserve more of our cash for overages during the build.

After the conversion to permanent loan, we will have limited income on which to meet mortgage payments and would prefer to put whatever is left of our 250K into paying down the loan balance. (There is no prepayment penalty on the loan; a refinance is not involved. Just as we paid our previous mortgage off early, with cash windfalls and by paying extra on our principal each month when we could. No prepayment penalty allows you to do either. All loans don't have it; ours will.)

The dilemma is this: during the build, while we're making gradually increasing interest-only payments as our cumulative total of draws increases, we'll be paying 6.3% interest to the bank on that balance. During that time we'll only be earning 5% interest on our savings. Thus, it's costing us 1.3%, net, on the money we borrow. So, if we borrow more money (put less cash down) we're losing that 1.3% net on a larger amount. And, at some point later in the build, depending on the bank's draw schedule, we won't be able to meet the construction loan payments without dipping into our savings. So, we'll lose a little interest earnings then on the savings we have to withdraw to meet the payments.

The only saving grace here is that the interest will be tax-deductible during the year we pay it.

I'm confused about your post. It sounds like at the end of the build, or during your conversion to the permanent loan, that you want to use the entire $250K...whether you're using all of it as the "down payment" or whether some of it is the "down payment" and some of it is an additional payment. Our lender for our construction-perm allows us to make payments throughout the life of our loan that recast (readjust the total...so if the loan was for $200K and you make a one time payment of $50K...the new total that we'd pay I + P on is $150K) the loan...as long as the additional payment is at least $5K and there is a $200 fee for doing so. It sounds as if your loan operates that way as well. So, this part I do understand...but

I'm perplexed about how you think that decreasing the down payment amount will shift risk to the bank during the build. If you do not plan on giving any down payment until your conversion period (which is what we are doing too...we have not sold our current home yet), then the payments during the build will be reflective of all draws. At some point, that means that the amount outstanding will include an amount higher than what your final total will be. So, on a construction budget of $450K, at some time during the build you will be at a level higher than your anticipated final loan total of $200K. You will be paying interest on the whole amount outstanding during the build...not just interest on the amounts up to $200K or $150K (If you change your loan amount). I don't see what changing the loan amount would do for you besides give you a cushion for overages. Are you sure that your bank doesn't expect you to provide the down payment up-front at closing, rather than at the conversion? If that is the case, then your posting makes sense. If you can only qualify for a $300K loan, then I think that's what the bank expects. We had to qualify for the ENTIRE amount of our construction loan...not just what our loan will be once we sell our house, pay this towards the loan, etc...Because if did not qualify for the entire amount, the bank would have a tremendous amount of risk on the line. The only thing that may be allowing you to do this is if the cost of your land is already operating as a significant down payment for you.

I'm sorry if I misunderstood your posting. Are you instead referring to having a higher loan amount at the end and comparing that differential to a savings account?

The way I interpret your post is that you are concerned with the 'here and now' part of your financing and you are looking for a way to be conservative with your risk during construction in case the unforseen happens. If I have that right...then what I would do is hold some of that money back and go for the larger construction loan. I don't know your complete financial picture but based on what you have shared that would seem to make sense. You may need that money during the course of construction anyway-upgrades and bills due before draws are available etc. This is a classis 'pros and cons' choice that you will have to make based on your situation and needs.

Personally, we are in a similar situation (own the land, nice chunk of equity from other real estate) and were considering just using our cash up front and getting a small loan for the rest. We are now thinking it might be wise to go ahead and get a construction loan just for the risk factors involved and for being able to keep some liquid cash on hand as the OP mentioned.

Also,some loans may recalculate the amortization if you make a large lump-sum payment but some do not, so make sure that you understand how your loan works.

Find a place that pays more then 5% for you $$.
That is a rather poor return.

I'm still confused...when are you planning on putting down the $250K? At closing or at conversion? This is an important distinction. I understand wanting to hold onto the money during the build...you're getting 5% on it, etc However, if you don't put it upfront...you WILL be paying interest on the entire amount outstanding during the build, therefore at some point during the construction period...you WILL be paying 6.3% interest on the $250K that you plan on putting down. The only way to figure out which is better is to crunch the numbers. Run a spreadsheet with the scenarios (holding onto the cash now and getting 5% for however long the build will take vs. putting up the cash at closing, losing that interest, but not paying 6.3% on this higher amount during the construction phase.) Pay close attention to the estimated length of the build...if you undershoot/overshoot this estimate it can skew the numbers.
Again, this is all with the assumption that your bank will allow you to not pay this down payment at closing...I would still question that. On my last posting I said that we had to qualify for the entire amount...I misspoke- we had to qualify for the ENTIRE construction amount + the amount we still owe on our home. This is why most people sell upfront (as well as the certainty of having their house sold, of course)...it is challenging to qualify for this much money.

"...we'll be paying 6.3% interest to the bank on that balance. During that time we'll only be earning 5% interest on our savings. Thus, it's costing us 1.3%, net, on the money we borrow..."

You didn't calculate in the value of the mortgage interest tax deduction.

One thing to be aware of is that if you take out a $300k mortgage and then pre-pay principal of $50k, you will still have a monthly mortgage amount equal to the $300k mortgage (the monthly payment doesn't get smaller), it will just be for a shorter number of years.

dixiedoodle:

Thanks for joining in. You understand the situation.
Yes, the land is worth enough to serve as the entire downpayment if we want it to. But we do want to eventually put the entire 250K into to it to reduce our mortgage. I think I'll have to get the bank's draw schedule and actually sit down and calculate how we'll come out under the bigger vs. smaller loan amounts, how much interest our savings will earn, etc., all along the way. I understand what you said about the net cost (interest payments less our savings earnings) being bigger all along on the larger loan. I'll have to calculate how much it'll cost us to do it that way.

I think as I read through all your posts, and consider it more carefully, I see that the main thing we would accomplish by getting a larger loan would be to preserve our cash for overages--at least for a longer time into the build. So my thinking needs to shift to: is that worth doing? I do get pretty uneasy about overages and there is not another source of cash readily available outside of the $250K.

How does it work with overages? Our builder contract is for a fixed price. We're to have continual internet access to our line item budget, so we can see where we're overspent and underspent. And we can shift things around from one line item to another. But early in the build we can't have much influence over that: a foundation isn't something we can select a less expensive one of. So, if at one of the builder's draw request times we're net "over" on the build do we pony up the cash to the builder then and there??

bj,
We were in a somewhat similar position when we built. We sold our home, put the cash from it into an account and got a construction loan.
As the build progressed, we paid for the draw in full each month from that cash. We also paid for the inevitable overages that way (excavation and foundation ran over big time).

When the cash got down to $50,000, I simply signed for the draw since I didn't know how much we'd need for overages and the inevitable immediate purchases needed for a new home. When all was done, I put the remainder against the principle.

That way we weren't paying interest to the bank during the build. I know the interest is tax deductible, but it's still interest paid. Our lender will re-amortize the loan at any time we put $5,000 or more on the principle (no fee for that). We've chosen not to reamortize since our goal is to have the home paid for in as short a time as possible.

The way our loan was set up, we were charged interest only on the cumulative amount of the draws, not the entire loan amount. I have a hard time believing that you'd be charged interest on 450K right at month 1. Perhaps I misunderstood your post?

zone8grandma:

"The way our loan was set up, we were charged interest only on the cumulative amount of the draws, not the entire loan amount. I have a hard time believing that you'd be charged interest on 450K right at month 1."

That's our situation; just like yours. I see what you're saying!! The cumulative amount of the draws won't differ no matter what size the loan. The draws are still based on the same building costs and stages of completion. The interest is based on the draws--not the loan.

You paid a different way than I was planning to and you're right--interest paid is interest paid; it's not like you get a full tax credit for it. I'm just so nervous about running out of our own cash, partly because we still own our current house and won't be selling it till after we move into the new one. So, we're carrying the expenses of it as well and don't know how long it will take to fix it up and sell it.

Everybody's situation is so different. It is very helpful to read about it and consider all the factors. This discussion is helping me more clearly define what the problem is.

bj,
If you choose to just sign for the draws and pay interest to the bank, the first month it's not so much. As the build progresses, the interest charge gets bigger and bigger. If you are still paying mortgage payments on your current home, by the time the new house is built, you could be making close to double payments.....

I understand from other posts your reasons for staying put until the new house is built...

Wishing you a smooth build.
z8g

zone8grandma: thanks. Fortunately, our current house is paid for. Otherwise there's no way we could do this.

"You didn't calculate in the value of the mortgage interest tax deduction."

Unless the 5% reutrn is not taxable, it comes out as a wash.
You only get a tax break at your final bracket for the interest in the loan, and that is the same amount you pay in the interest income.
As long as you consider the interest received and payed on an equal footing (either both before taxes or both after taxes) it typically comes out as a wash.

If I had some flexibility in a loan arrangement I would first try to shorten the term. A 20 year term costs considerably less than 30.

Much has to do with how big a part of your liquidity that $250K is. If I have a total of $300K liguidity I would not sink $250 cash in a house. I'd rather hold back some liquidity as long as the interest rate on the mortgage is a good rate.

I just closed on a 6% 30-year loan which I plan to pay off over a 15-year period. But I just wanted the flexibility to have a lower payment if I got in a squeeze at any point during the term. My note has no penalty for early payment, I can make any extra payments I want any time I want.

My construction loan was 7.75%, that 6.3% is very good for an interim loan.

You could sink alot of cash in the house and if you don't have a nice cash reserve something could happen and you would need to sell quick, maybe not at full value, and you would lose some of your equity. The small spread between interest earnings and interest paid is a small price to pay for the flexibility and security of having cash in the bank.

5% is not a bad return for safe investments. The stock market or bond from an iffy debtor might yield more, or might go bust.

brickeyee: It probably will be a wash. Just trying to hold onto some cash for awhile during the build and not have it cost me to do it.

mightyanvil: the 20 year will cost less, but we are trying to get the monthly payment as low as possible, so we want a 30 year to do that. We will pay it off long before 20 years even, just not for a few years yet, after we recover from the build

texas_al: I'm with you on the paying it off early. I'm thinking more now of not putting the full $250K we'd allocated into it. Keep some of that in the bank at 5% till after we sell our current house and see where we stand. If worse comes to worse we gradually withdraw some of it to cover monthly mortgage payments.

All: This has been very helpful for getting a better view from all sides. Thanks!