The Ins and Outs of Construction Loans and Permanent Financing

Construction loans and permanent financing are two common options for funding a new home build or major renovation project. While they share some similarities, there are key differences buyers should understand when weighing the pros and cons of each. This comprehensive guide examines how construction loans and permanent financing work, who they best serve, and what borrowers need to know to choose the right loan for their building goals.

What Are Construction Loans?

Construction loans, also called builder loans, provide short-term financing to fund the building or major renovation of a home. The loan covers costs like land purchase, materials, labor, and other construction costs.

With a construction loan, interest-only payments are made during the building phase, which typically lasts 6-12 months but can vary depending on the project scope. Once the home is move-in ready, the construction loan must be paid back in full or refinanced into permanent financing like a traditional mortgage.

Construction loans are ideal for those wanting to build a custom home or embark on a major remodel requiring specialized financing Key features include

• Interest-only payments during construction

• Short 6-12 month term

• Loan amounts covering total building costs

• Paid back once project complete

• Requires refinancing into permanent mortgage

Construction loans involve more complex underwriting than standard mortgages. Borrowers generally need excellent credit, low debt, and the ability to make high down payments. Rates also tend to be higher than traditional mortgages.

What Is Permanent Financing?

Permanent financing refers to long-term mortgage loans used to pay off a construction loan once building completes. This provides affordable monthly payments over an extended period, usually 15-30 years.

The most common type of permanent financing is a conventional fixed-rate mortgage. Other options include VA, FHA, and USDA loans. Jumbo loans are available for luxury projects requiring permanent financing over conventional conforming limits.

With permanent financing, loan approval is based on the home’s appraised value after construction rather than building costs. The home serves as collateral, carrying less risk than construction loans.

Permanent financing offers:

• Long 15-30 year repayment terms

• Lower monthly payments

• No balloon payment due at construction completion

• Underwriting based on finished home value

• Options like fixed, ARM, government, jumbo loans

Since the home is complete before closing on permanent financing, underwriting requirements are less stringent than construction loans. Lower credit scores and debt ratios may be accepted.

Construction-to-Permanent Loans

Construction-to-permanent loans blend short-term construction financing with long-term permanent financing in a single loan. This avoids the need to get a construction loan, then refinance into permanent financing after project completion.

With a construction-to-permanent loan:

• Construction financing covers build costs

• Interest-only payments made during construction

• Loan converts to permanent mortgage once construction finishes

• Only one loan application and closing needed

Construction-to-permanent loans simplify the building loan process. However, they require excellent credit, income, and cash reserves to qualify. Government-backed versions like FHA and VA construction-to-permanent loans have less stringent requirements.

Choosing the Right Building Loan

Deciding between a construction loan, permanent mortgage, or construction-to-permanent loan depends on your project, finances, and goals. Key factors to consider include:

Project Type: Construction loans work for building a new home or renovations like additions and remodels. Permanent financing is for finished homes. Construction-to-permanent loans allow building then transitioning to a mortgage.

Credit and Income: Construction loans call for pristine credit and robust finances. Permanent financing is more flexible. Construction-to-permanent loans require excellent credit too.

Collateral: Construction loans are riskier with no existing collateral. Permanent financing is backed by the completed home. Construction-to-permanent loans transition from high to low risk.

Interest Rates: Construction loans feature higher rates than permanent mortgages. Construction-to-permanent loans offer lower permanent financing rates after building.

Closing Costs: Construction then permanent financing requires two sets of closing costs. Construction-to-permanent loans offer one-time closing costs.

Carefully weighing these key differences allows buyers to identify the ideal loan for their building plans and financial situation. Consult with a loan officer early on to map out the best road forward. With the right financing approach, you can turn your dream home into a reality.