One thing to consider is the incredibly low current interest rates. There is a good chance that in the foreseeable future you will earn more money in a money market than you will pay in interest. Certainly true for CDs and other safer investments. Definitely true, if the past is prologue, with dollar cost averaging in the stock market. It might be worth taking out the mortgage and keeping it for the tax deduction and cheap money aspect. Just another perspective.

AM3 - I would just disagree but all that maybe for another forum. The tax hit on investments along with the impending loss of the mortgage tax deduction combined with a terrible long term fiscal outlook.... but I digress.

Having had a construction loan, there is zero value in the bank inspections. That of course was my experience and my opinion - YMMV.

I don't think I would build out of state unless I had a big stick over the builder's head or I somehow knew them personally or professionally. I wouldn't trust a recommendation from someone I didn't know personally. All that is very hard to do from afar.

Sounds like you are building a modest house so the downside is less. But don't expect a banker to protect you. Hire a consultant, trust your builder or count on code inspections. Really - you just need some critical time point inspections.

I would get the construction loan. Having it doesn't require you to take draws. However it does provide some flexibility, if your situation might change.

The inspections provided by the bank are next to worthless. The bank is not interested in construction quality, etc. the bank is interested if you are able to finish the house before you run out of money. They couldn't care less about much else.

As to building out of state, I would recommend putting the build job off until you have an opportunity for better oversight. Sell your primary house, move to your build locale, rent, buld house, move again. Yeah two moves is inconvenient, but is a small price of insurance to have oversight and to ensure your house is actually built right. Also by selling your house first, you sit on a large amount of cash, and nothing offers more flexibility than that.

We did a construction loan on ours and we are almost finished. Some things I learned. 1) Don't forget that MOST construction loans have a deadline date and penalties for going over that date. Ours went over, as do most and now we got a 2 point penalty and hoping the builder is going to pay the penalty like he claims.
2) There usually is an additional inspection fee which YOU will have to pay for any inspections beyond what is contracted. We got hit with one. The builder called for the 4th draw and the bank came out to inspect. The builder had most of the 4th draw items finished, but not all, although he had items done from the 5th draw which he thought would balance out. The bank was unhappy about that and required an additional inspection that I must pay for and hope the builder will compensate me for it.
3) Yes, as noted above, the banks inspections are worthless. I happened to be at the home one day talking with the builder when the bank inspector came. It was siding and insulation. There was no siding on the front of the house since it gets stone and stucco, but the back and sides had siding. The inspector never looked at the sides and back and said "I am assuming there is siding on the back and the front gets stone" the builder replied "yup"
The inspector then stuck his head in the door, not his feet, just his head, saw there was insulation and said, "I am assuming there is insulation upstairs too" builder says "Yup" and the inspector says "OK...gotta run" and drove off. Less than 30 seconds on the property.
We know our builder, but I don't know if I could even trust him if I were not close by to watch over them. One good thing the bank will do for us at conversion time is if all contracted items are not finished, but CO is acquired, they will withhold an amount which will certainly encourage the builder to come back quicker and finish.

I have more confidence in the stock market than you David and the ability to minimize tax consequences ;), although I do have the same concerns about the mortgage interest deduction . . I think though that is off the table until the housing industry recovers which may well be 5 years or more.

Another thing I would caution you to do is to compare interest rates on your HELOC and the construction loan. We have an existing HELOC and the interest rate on that was a quarter of a point lower than the rate on our construction loan. Unfortunately we needed to use both as our HELOC did not come close to covering our build costs but we put in all our cash first, then used the HELOC with the lower interest rate (interest only option), and will have to tap our construction loan at the end of the month for the next draw. When we sell our house, the HELOC will be paid off and we will have borrowed less than we would have otherwise (we are trying to avoid an enormous mortgage payment). We also have the benefit of borrowing a good bit of money at well under 4 percent.

Since I have a HELOC and soon to have a construction loan at a higher rate, it is worth mentioning that HELOC have far more restrictions regarding tax deductibility (esp with AMT).

You can only deduct the first 100k of a HELOC, which was our HELOC limit on our current house. I don't understand the AMT deal anyway - we get hit big with the AMT some years and not others. Very confusing!!! But something to consider for those that understand it!!!

Thanks all. I appreciate the comments and insight.