The Ins and Outs of the Construction to Permanent Loan Down Payment

Construction to permanent loans, also known as one-time close or single close loans, allow you to finance the construction of a new home and convert it into a permanent mortgage once construction is complete – all with one loan and one closing. This streamlined process helps save time and money compared to obtaining separate construction and permanent financing.

While construction to permanent loans offer many advantages they also come with stricter eligibility requirements than standard mortgages. One key factor is the down payment. Let’s take a closer look at what’s required and why.

Typical Down Payment Requirements

Most lenders require a minimum down payment of 20% for a construction to permanent loan Some may even ask for 25-30% This is substantially higher than the 3-5% down often needed for a conventional mortgage.

The reason behind the larger down payment is the higher risk involved with new construction. With a traditional mortgage, the home serves as collateral for the loan. But with construction financing, the home hasn’t been built yet. Requiring more money upfront helps offset the chance that the borrower defaults before the home is completed.

While 20% is the most common threshold, down payment rules can vary by lender. Government-backed loans like FHA, VA and USDA programs may offer lower down payment options, while portfolio lenders that hold loans on their own books tend to have more flexibility. Shop around to see if you can find a lender willing to accept less than 20% down.

Factors That Affect the Down Payment Amount

When determining down payment requirements, lenders look at several factors related to the borrower’s finances and the construction project itself:

• Credit score and debt-to-income (DTI) ratio – Borrowers with higher credit scores and lower DTIs are seen as lower risk and may qualify for a lower down payment. To be approved, most lenders require a credit score of at least 680 and a DTI around 45% or less.

• Lot ownership – If you already own the land the home will be built on, lenders consider this less risky than having to purchase land. Expect lower down payment requirements in this case.

• Builder reputation and licensing – An experienced, licensed general contractor lowers risk. Working with a first-time or unlicensed builder may mean putting more down.

• Cost of construction – The higher the project costs, the higher the down payment may need to be. Luxury new construction often calls for a larger percentage down.

• Loan product type – Government-backed loans allow lower down payments. Conventional construction loans involve more risk and therefore higher down payment requirements.

• Permanent loan type – Applying for a fixed-rate permanent loan means your interest rate will be set early on. This reduces risk for lenders versus an adjustable-rate mortgage, potentially earning you a break on the down payment.

Coming Up with the Down Payment Funds

Once you know how much your lender expects for a down payment, you’ll need to figure out how to come up with the funds. Here are some options to consider:

• Tap into personal savings, like an emergency fund or other bank accounts. Just be sure to leave enough leftover in case of unexpected expenses.

• Withdraw funds from investment accounts, like stocks, bonds or mutual funds. Be aware of taxes and early withdrawal penalties.

• Use a 401(k) loan if your plan allows. These typically need to be paid back within 5 years to avoid taxes and penalties.

• Take advantage of gift funds from relatives. Lenders usually allow this as long as the gift isn’t tied to repayment.

• Ask the seller for down payment assistance if you’re purchasing land. This can take the form of a price reduction or seller credit.

• Look into down payment assistance programs offered by state and local governments, nonprofits and even some employers. These provide grants, forgivable loans and other benefits to qualifying applicants.

• Consider a home equity line of credit (HELOC) or cash-out refinance if you have sufficient equity in an existing home. The funds can then be applied to the new construction down payment.

Down Payment Pros and Cons

While forking over 20% or more upfront can be difficult, making a substantial down payment does come with several advantages:

Pros

• Improves chances of approval since you’re less of a risk

• Allows you to qualify for better loan terms like a lower interest rate

• Avoids paying private mortgage insurance (PMI)

• Lowers monthly mortgage payments by reducing the amount borrowed

• Helps ensure you can cover cost overruns if the project goes over budget

Cons

• Requires large sum of cash upfront, which could deplete savings

• Ties up money that could potentially be invested elsewhere

• Puts you at risk of losing equity if property values decline

Carefully weigh the pros and cons when deciding how much to put down. Aim to put at least 20% down if possible, but don’t drain all your funds in the process.

Alternatives to a Large Down Payment

If you want to move forward with a construction loan but can’t come up with 20% down, you may have to pay a higher interest rate or look for alternative options, such as:

• An FHA or VA loan with a lower down payment requirement

• Using land or another asset as additional collateral

• Finding a family member to co-sign on the loan with you

• Working with a portfolio lender that offers more flexibility

• Waiting and saving up a larger down payment over time

While they allow you to put less money down, these choices can make the loan more expensive or complicated. But they give you a chance to break ground on your new home build when you can’t meet the 20% down payment benchmark.

Weighing Your Options

Construction to permanent loans provide a simplified path to financing new construction. But you’ll need to put more cash down upfront to mitigate the increased risk lenders face. Carefully assess your finances, research lender requirements, and explore ways to tap into funds for your down payment. With proper planning, you can cover the deposit while keeping your savings intact. This helps ensure a smooth journey from breaking ground to moving into your brand new custom-built home.