What is a construction-to-permanent loan?

A construction-to-permanent loan is one form of construction financing borrowers use to build a home. It can help with obtaining the land, materials, permits and more. Many types of lenders offer construction-to-permanent loans, but you’ll most often find them at a bank or with a lender that specializes in construction financing.

What is a construction-to-permanent loan?

A construction-to-permanent loan, also known as a one-time or single-close loan, is a type of mortgage for those building a home. It funds the purchase of land and the home’s construction. Once the home’s built, the loan converts into a traditional mortgage, usually with a 15- or 30-year term.

Conventional construction-to-permanent loans can have fewer restrictions than government-backed loans.

How does a construction-to-permanent loan work?

Construction-to-permanent loans function in two phases: construction and post-construction. During the construction phase, the lender authorizes payments, or draws, to cover the cost of land, materials, labor, permits and other expenses. The lender works closely with an inspector to ensure the construction continues on-schedule and on-budget.

The construction phase typically lasts about one year, but can vary depending on your lender, permitting, scheduling and the size of the project. During this time, you might only be required to make interest payments. Once construction is completed, the loan converts into a traditional mortgage, and you’ll start repaying the mortgage principal and interest.

Eligibility requirements for construction-to-permanent loans

  • Down payment: For a conventional construction-to-permanent loan, you’ll generally need a down payment of 20 percent, although some lenders allow for much less, as low as 5 percent.
  • Credit score: Lenders typically want to see a great credit score for this loan type, with a minimum of 680.
  • Debt-to-income ratio (DTI): The lower your DTI ratio, the greater your chance of approval for a construction-to-permanent loan. You’ll want a DTI ratio of 45 percent or below to boost your application.
  • An estimated appraisal: You’ll need to work with an appraiser to determine the completed home’s estimated value. The lender will use information from the inspector to approve draws to the builder.
  • Project approval: The lender needs to review your project plans before approving the loan. That means you’ll need to submit a realistic budget and schedule, professional blueprints, a copy of the deed for the land and any other related documentation.
  • Architect and contractor approval: You’ll need to hire licensed, professional builders and submit copies of their licenses, certificates and/or resumes to your lender.
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Pros and cons of construction-to-permanent loans

Pros of construction-to-permanent loans

  • Only one set of closing costs: The beauty of a construction-to-permanent loan is that it’s a package. Instead of taking out a construction loan, then a mortgage, a construction-to-permanent loan combines the two, which limits your closing costs.
  • Ability to draw funds as needed: Construction-to-permanent loans pay out to builders as the project progresses.
  • Interest-only payments during construction: Many construction-to-permanent loans only require you to make interest payments during construction. This can make budgeting easier, especially if you have rent or another mortgage to pay while your new home is being built.

Cons of construction-to-permanent loans

  • Bigger down payment than other mortgages: Conventional construction-to-permanent loans are riskier for lenders because the home that normally serves as collateral isn’t built. Because of this, you could be required to make a higher down payment.
  • Cost overruns: If the project goes over budget (and most do), the loan amount might not cover it. In this case, you’d have to pay out of pocket or get another loan to cover the additional costs.
  • Higher interest rates: Construction-to-permanent loans, in general, are more costly than conventional mortgages. What’s more, the interest rate on the construction portion of the loan might exceed the permanent mortgage rate later on.
  • More paperwork: Because a construction-to-permanent loan combines a construction loan with a mortgage, you’ll need more documentation than a traditional mortgage. That means submitting blueprints, a budget and licenses for contractors.

Alternative to construction-to-permanent loans

Home equity line of credit (HELOC): If you have a house, you can tap into your home equity with a HELOC. With enough equity, you could use a HELOC to fund the construction of another home. However, keep in mind you’ll need to use your home as collateral and pay out of pocket for any construction costs not covered by the HELOC.

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