Construction-to-permanent loans assist homebuyers when building a home from the ground up. When financing the construction of a new home, a construction-to-permanent loan offers several advantages compared to other types of loans. Homebuyers considering building their own home can utilize this type of loan to secure a better deal on their purchase.
What Is a Construction-to-Permanent Loan?
Construction-to-permanent loans provide financing for homes that must be built from scratch or significantly renovated. A construction-to-permanent loan differs from a traditional mortgage based on the homebuyer’s need to finance the actual building of the home before the purchase.
During the work phase, contractors or builders receive lump sums, also called draws. After construction, the loan balance converts into a traditional mortgage loan, often without needing a second approval from the lender. While under construction, the borrower makes interest-only payments on their loan.
The streamlined features of a construction-to-permanent loan make it attractive to anyone looking to build and buy a home. Homeowners typically arrange their finances before any construction begins on the property. After construction wraps up on a new home, a construction-to-permanent loan transforms into a traditional loan.
Construction-Only Loans vs. Construction-to-Permanent Loans
There are two types of loans that finance the construction of a home: construction-only loans and construction-to-permanent loans. With a construction-only loan, the contractor or builder draws on the loan to complete the approved building project. Construction loans end when the construction wraps up, and the borrower pays the final balance. Should a homebuyer need to finance their home through a mortgage, they would obtain a conventional loan after construction.
Alternatively, a construction-to-permanent loan, also referred to as a construction-to-completion loan, provides funding to build and purchase a home. The initial construction loan typically shifts to a traditional mortgage at the end of the building process. It is usually easier to qualify for this loan because the mortgage lender can use the built house as collateral. In a construction loan, applicants must meet more eligibility requirements as the lender cannot use an unbuilt home as collateral.
How Do Construction-to-Permanent Loans Work?
Conventional mortgages use a built home as collateral if the borrower defaults on their mortgage payments.
Secured loans such as mortgages use the value of your home as collateral. Construction-to-permanent loans consist of the following components, and potential homeowners should consider the following when leaning toward this type of loan:
Initial Lower Payments
During the building phase of a construction-to-permanent loan, the borrower makes interest-only payments. Since mortgage loans require a monthly payment including both the principal and interest, borrowers can save money on future payments by making interest-only payments during construction.
Pricing
Construction-to-permanent loans involve more risk during the building phase when the unfinished home represents the only collateral. Thus, construction-to-permanent loan rates generally outprice mortgage rates. These higher interest rates compensate the lender for the additional risk.
As of October 2022, conventional mortgage interest rates sit around 7%, meaning a construction-to-permanent loan interest rate can exceed this. High-interest rates can become a burden for potential homebuyers, meaning those considering a building or renovating their property should consider this additional financial risk.
Term
Construction-to-permanent loans divide their term into two stages. The first term covers the time given to complete construction, generally anywhere from six months to two years. After building, the loan converts to a traditional mortgage, with a typical payoff, such as a fifteen or thirty-year term.
These loans are more advantageous than construction-only loans because they seamlessly transfer into the second stage and acquire a conventional mortgage term. This transition saves homebuyers the hassle of finding, applying for, and receiving approval for a second loan after construction completion.
Approval Process
Credit and income requirements are generally stricter for construction loans. The lender will request additional documentation, such as a completed building plan. Your lender may also ask to review your contract with your builder and any available cost estimates to support the number of construction funds requested.
Most lenders require that the potential home meet several requirements to acquire this loan type. Typically, homes must be an owner-occupied primary residence or someone’s second home. Some building types that do not qualify for this loan include townhouses, condos, and multi-family houses. Manufactured homes may qualify for construction-to-permanent loans.
Pros of a Construction-to-Permanent Loan
If you’re considering building a home, it is worth your while to investigate your potential financing options thoroughly. Similar to any loan offer, construction-to-permanent loans come with their own set of pros and cons, offering the following benefits:
Customized Loan Structure
Homebuyers interested in building their own home can use a construction-to-permanent loan’s unique structure to take advantage of the streamlined financing approach. This type of loan caters explicitly to a build-and-buy situation, where other loans may not fit as well in terms of cost, timing, and payments.
One closing
Construction-to-permanent loans convert to a traditional mortgage using a one-closing structure. Unlike a construction-only loan, a construction-to-permanent loan allows homebuyers to close on one loan and simply their homebuying process. This saves time and hassle for buyers with a lot on their plates.
Rate Locks
When using a construction-to-permanent loan, you’ll immediately know what to expect for your interest rates for both the construction period and the final mortgage. If you choose to wait and secure a separate mortgage, you’ll bear the risk of rising interest rates during the construction phase, leaving you with a larger bill to pay.
Interest-Only Payments
While still in the construction phase of homebuilding, borrowers only pay the interest on their loans. Paying off the interest helps decrease the principal amount before moving into the home.
Cons of a Construction-to-Permanent Loan
While construction-to-permanent loans come with their own set of benefits, there are also some drawbacks that homeowners should note prior to moving forward with a signing. Consider the following:
Locked in Terms
Locking in terms with a construction-to-permanent loan gives you peace of mind. Still, you should also review other financing options to make sure you’re not missing an opportunity to secure better mortgage terms in the future. Homebuyers may be able to find a better deal when shopping around with other lenders. As with any financing process, homebuyers must research and review several options instead of going with the first thing they find.
Time Limits for Completion
Construction-to-permanent loans generally set a time limit for the fulfillment of construction. Supply chain delays, price changes of construction materials, or the decision to expand the scope of a building project may cause you to miss deadlines set by the lender. This could translate into additional fees or penalties. If this happens, you may need to renegotiate before moving forward with the next stage of your building project.
Higher Interest Rates and Down Payment
Construction-to-permanent loans come with more associated risk than a traditional mortgage, as lenders cannot use an existing home as collateral. Therefore, lenders may require homebuyers to meet more stringent requirements, such as paying a larger down payment or acquiring a higher interest rate.
It’s a good idea to calculate the cost of building and buying your home using several financing options before making a final decision.
Making a Construction-to-Permanent Loan Work For You
If you’re considering acquiring a construction-to-permanent loan, take the time to talk to several lenders and a financial advisor about your options. Work with your builder to establish a solid construction timeline and ensure you understand the cost of building a new home. The more information you can bring to the table, the higher your chance of finding a lender that can offer you the best financing for your new home project. Construction-to-permanent loans provide a flexible financing option for those looking to build or renovate their home, making them a favorable choice amount homebuyers.
