How Construction Loans Convert to Permanent Financing

Getting a construction loan can be an excellent way to build your dream home But what happens after the construction is complete? Typically, construction loans are short-term and you’ll need permanent financing once the house is built That’s where construction-to-permanent loans come in.

In this article, we’ll break down exactly how construction loans convert to permanent mortgages. We’ll cover:

• What is a construction-to-permanent loan?
• How construction-to-permanent loans work
• Requirements and eligibility
• Pros and cons
• How to apply
• Alternatives to construction-to-permanent loans

What is a Construction-to-Permanent Loan?

A construction-to-permanent loan combines a construction loan with a permanent mortgage all in one. So instead of getting a construction loan to build the home and then applying separately for a mortgage it’s all handled with one loan and one closing.

With this type of financing, the construction phase works like a typical construction loan. The lender disburses payments to the builder at certain milestones. Once construction is complete, the loan converts to a fixed-rate permanent mortgage.

Construction-to-permanent loans streamline the process of building and financing a home. You only pay one set of closing costs and don’t have to requalify for a mortgage after the construction period.

How Do Construction-to-Permanent Loans Work?

Construction-to-permanent loans have two distinct phases:

1. Construction Phase

This phase functions like a standard construction loan. Here are some key things to know:

• The lender will only release funds incrementally as work is completed to the satisfaction of the bank and its inspectors.

• Draw requests are submitted by the builder for disbursement at specific milestones outlined in the loan agreement.

• An independent inspector verifies work is done per the agreed-upon schedule and budget before the bank releases payments.

• Loan payments during construction may only cover interest depending on the type of construction-to-permanent loan.

The construction phase typically lasts around 6-12 months but can vary based on factors like permitting, weather, size of home, and more.

2. Permanent Financing

Once the home is built and inspectors sign off, the loan converts to permanent financing. This is most often a traditional 15- or 30-year fixed-rate mortgage.

Now the regular mortgage payments kick in, covering principal, interest, taxes, and insurance (PITI). The home serves as collateral for the permanent financing portion of the loan.

Construction-to-Permanent Loan Requirements

Since these loans carry more risk for lenders, eligibility requirements tend to be stricter than a typical mortgage. Here are some common requirements:

• Down payment – Expect to put 10-20% down

• Credit score – Minimum 680 credit score or higher

• DTI ratio – 45% or lower

• Appraisal – Home’s estimated value once completed

• Builder approval – Licensed, reputable builders only

• Architect approval – Copies of architect licenses and certificates

• Plans – Detailed budgets and blueprints

Conventional loans generally have more flexible criteria than government programs like FHA or VA loans.

Pros and Cons of Construction-to-Permanent Loans

Let’s look at some of the key advantages and disadvantages of construction-to-permanent loans:

Pros

• Only one set of closing costs
• Interest-only payments during construction
• Draw loan as construction progresses
• Streamlined process

Cons

• Higher downpayment than typical mortgages
• Higher interest rates
• More stringent credit score requirements
• Additional paperwork and requirements

For many homebuilders, the convenience factor of having everything wrapped into one loan outweighs the stiffer criteria and rates. But weigh the pros and cons carefully to decide if it’s the right solution for your construction project.

How to Apply for Construction-to-Permanent Loans

Follow these steps when applying for construction-to-permanent financing:

• Find a qualified builder and architect. Get references and look at examples of their work.
• Shop lenders and compare loan estimates. Look for construction financing experience.
• Submit loan application and paperwork to show income, assets, credit, etc.
• Provide the lender with budgets, blueprints, schedules, permits, licenses, and other required documents.
• The lender will order appraisals and inspections at various stages.
• Builder’s risk insurance is often required during the construction phase before permanent hazard insurance kicks in.
• Loan closes once, instead of two separate closings for construction loan and mortgage.

Work closely with your lender throughout the process to ensure proper draw requests and a smooth transition to permanent financing.

Alternatives to Construction-to-Permanent Loans

Some other options for financing construction include:

• FHA 203(k) Loan – Combines purchase/refinance with rehab funds
• VA One-Time Close – No downpayment required
• Construction-Only Loan – Short-term financing that must be repaid once home is built
• Home Equity Loan – Leverage equity in existing home
• Cash-Out Refinance – Tap equity via a refi; can carry higher rates/fees

Look at all your choices to get the best construction and permanent financing for your situation.

The Bottom Line

Construction-to-permanent loans simplify the process of building and financing a home. If you meet the eligibility requirements, they can be an efficient option that combines construction financing and a mortgage in one. Just be sure to look at the fine print so you know the costs, terms, timelines, requirements and other details before committing.