The cheapest option is to pull equity through a secured line of credit on the existing property, because the interest is competitive, you only pay interest on what you use, and there are typically no lender or broker fees. If that property does not have enough equity, the next best option is to set up secured lines of credit on other properties in your portfolio.
Construction loans typically include lender fees of 2 percent to 4 percent, broker fees, and interest rates set at prime plus 2 percent to prime plus 4 percent. Lenders may also deduct an interest reserve upfront and hold back 10 percent of every construction draw until the project is finished to protect against construction liens.
You should choose a variable-rate mortgage because it keeps your options open and allows you to refinance or switch lenders with only a three-month interest penalty when you are ready to access the higher post-construction value. A fixed-rate mortgage could cost you significantly more to break if you need to refinance or top up the loan after adding the unit.
You should use construction financing if you plan to demolish the existing house that has a first mortgage on it, because the construction loan will pay off that existing mortgage and provide funds to build. If you are not demolishing the existing asset and you have available equity, a secured line of credit is usually the cheaper and simpler choice.
It is critical to validate your exit financing upfront because not all lenders will consider the increased value or rental income after construction, and your unique credit, income and financial situation will determine what loan terms you actually qualify for. Working with a qualified advisor to order as-is and as-complete appraisals before you start ensures you know exactly what refinance rate, loan-to-value and amortization you can expect upon completion.
