How Does a Construction to Permanent Loan Work?

Maryland real estate agents explain models of housing estates in projects to elaborate to clients The real estate market is aging, with over half of owners living in homes built before 1980. That can make finding your dream house challenging unless you hire a professional to build it. As stressful as that sounds, construction-to-permanent financing streamlines the process.

Learn more about this type of loan to see if it is right for you. If so, you can work with a lender to obtain financing.

A construction-to-permanent loan, also known as a one-time close or single-close loan, is a mortgage product designed for homebuyers who want to build their dream home. This type of loan provides financing for both the construction phase and the permanent end loan in a single loan closing, making the process more convenient and affordable.

What is a Construction-to-Permanent Loan?

A construction-to-permanent loan combines the features of a short-term construction loan and a traditional long-term mortgage into one loan. Here’s how it works:

You only go through one loan application underwriting and closing process. This saves you time and money on multiple sets of fees and closing costs.
The lender provides funds to purchase land and cover construction costs as they are needed in draws during the building phase
Once construction is completed and the home is ready to be occupied, the construction loan seamlessly converts to a fixed-rate permanent mortgage without any additional approvals needed.
The interest rate is locked in upfront for the permanent financing portion, providing payment stability

Essentially, a construction-to-permanent loan gives you one loan to finance the entire home building process from start to finish.

Benefits of Construction-to-Permanent Loans

There are several advantages that make construction-to-permanent loans an attractive financing option for custom home builds:

One closing. You only go through the mortgage process once, saving significant time and reduce closing costs.
Interest rate lock. The rate for the permanent financing is locked in upfront, protecting you from rate hikes during construction.
Easier to qualify. You only need to qualify once for the combined loan amount.
Cost savings. You save on multiple appraisal and inspection fees required for two separate loans.
Draw process. Funds are disbursed in installments as needed to pay builders during each stage of construction.
Automatic conversion. Once construction is finished, the loan seamlessly converts to a permanent mortgage requiring no other paperwork or underwriting.
Payment flexibility. Many lenders offer interest-only payments on disbursed funds during construction, keeping payments lower until the project is done.

How Do Construction-to-Permanent Loans Work?

Construction-to-permanent loans have a multi-step process designed to finance the entire home building project through one lending vehicle:

You apply and get qualified for the combined construction and permanent loan based on your finances and the total loan amount needed to cover land, construction costs and permanent financing.
At closing, you finalize loan documents and the lender sets up a construction loan account and permanent mortgage account. Funds are earmarked for each stage.
The construction phase begins. The lender disperses payments to the builder via periodic draw requests as specific milestones are met. Draws pay for completion of foundations, framing, roofing, plumbing, etc.
Once the home is finished, the construction loan account closes and any remaining funds are automatically transferred to the permanent mortgage account.
Now the permanent mortgage starts, allowing you to move into your new custom home. You begin making principal and interest payments amortized over the loan term like a regular mortgage.

Throughout the process, you work with one loan officer and the construction and permanent financing is handled together in in synchronized stages, making the lending process simple and seamless.

What Do You Need to Qualify?

While construction-to-permanent loans allow for combined qualifying, you still need to meet the lender’s eligibility standards for both construction loans and permanent mortgages, including:

A minimum credit score of 620 or higher
Stable income and employment history
Down payment of around 10-20%
Debt-to-income ratio below 45%

Work to improve your credit profile before applying. The stronger your finances, the better mortgage rate you can qualify for.

How Much Does a Construction-to-Permanent Loan Cost?

A construction-to-permanent loan combines costs for financing the construction itself and the permanent mortgage in one bundled set of upfront fees, including:

Origination fee of around 1-2% of the total loan amount
Application and underwriting fees of $500-$1,000
Appraisal and inspection fees of $300-$500 each
Title insurance and escrow fees of $700-$2,000

There are no added closing costs for the permanent mortgage conversion once construction is complete. Shop and compare loan estimates from multiple lenders to find the best rates and fees combination.

Tips for Getting Approved

Because construction loans carry more risk, getting approved for a construction-to-permanent loan can be challenging. Follow these tips to boost your chances:

Get pre-qualified – Work with a lender early to assess your financial standing and get pre-qualified before making an offer on land or signing a construction contract.
Know your budget – Have a detailed construction budget finalized for how much you need to borrow. Cost overruns risk loan denial.
Pick reputable builders – Lenders want to see reliable builders with a proven ability to finish quality projects on time and within budget.
Have contingency funds – Set aside at least 10-20% as a contingency reserve for unexpected overages during construction.
Check your credit – Maintain excellent credit and minimize debts. Open credit only as needed so your credit profile remains stable.
Document income/assets – Be ready to provide pay stubs, tax returns, bank statements to substantiate your financial position.

Following these best practices will demonstrate to lenders you are ready for a construction project and lower the risk of funding your loan.

Alternatives to Construction-to-Permanent Loans

Construction-to-permanent loans have excellent benefits but also stricter eligibility standards. If you don’t qualify, here are some alternatives to consider:

Two-loan option – Get a short-term construction loan first, then a separate permanent mortgage after building completes. This requires two closing processes.
Renovation loan – For major remodels of an existing home instead of new construction. Funds cover purchase plus planned improvements.
203(k) rehab loan – FHA-insured mortgage that includes funds to renovate a distressed property, requiring only 3.5% down.
HomeStyle loan – Conventional renovation loan financing purchase and renovations in one loan.
Home equity loan – A line of credit using your home’s equity, which can be tapped for home improvement projects.

Talk to your lender to find the right loan or combination of financing strategies that match your renovation plans and financial capabilities if a construction-to-permanent loan isn’t feasible.

The Bottom Line

Construction-to-permanent loans are an excellent, simplified way to finance building a custom home in one fell swoop. You get the flexibility of draws for construction costs paired with a pre-locked permanent mortgage wrapped up in one loan. Just be sure to budget carefully, pick reliable builders and contractors, and run the numbers to be sure it makes sense for your financial situation. With proper planning and preparation, a construction-to-permanent loan can make building your dream home smooth, convenient and affordable.

Requirements for Obtaining a Construction-to-Permanent Loan

In a traditional mortgage loan, lenders are able to minimize risk by using the existing property as collateral. Thus, if the borrower defaults, the lender can take steps to seize the home.

Without an existing home, construction loans are far riskier for banks requiring them to have rigorous requirements in place.

Borrowers need to first demonstrate that they can repay the loan. To ensure borrowers meet the criteria, lenders consider assets, income, employment history, debt-to-income ratio, and other factors.

Also, most lenders will not consider applicants with credit scores below 680, and some require a score of 700 or above. The increased risk also impacts the down payment amount for construction-to-permanent financing.

While getting a traditional mortgage for as little as 5% down is possible, lenders typically require at least 20% for construction loans. In fact, the down payment can be as much as 30% for borrowers with weaker credit or less income.

Banks also expect borrowers to choose reputable builders before approving them for construction loans. Due to the risk, lenders want to work with builders who have proven that they build high-quality homes within the predetermined timeline.

Finally, many lenders review an estimated appraisal before approving loans. They want to know how much the home will be worth once completed before extending a financing offer.

Upon approval, borrowers can withdraw funds to pay for construction costs. The lender may visit the site to ensure milestones are completed before dispensing the money.

Because the approval amount is based on the estimated construction costs, the project may end up under or over budget. If the project is under budget, the lender will take back the excess funds, and the borrower will not be responsible for repaying that amount.

However, the borrower cannot apply to increase the amount of the construction-to-permanent loan if the builder exceeds the budget. Instead, the borrower can explore other financing options with the lender.

Expenses Covered By Construction-to-Permanent Financing

Construction-to-permanent loans are used to pay for construction-related expenses. Typical expenses include the following:

Cost of the land
Materials
Labor
Permits

Borrowers cannot use the funds to pay for furniture or other expenses unrelated to the construction.

Construction Loans: What They Are and How They Work (IN DETAIL)

FAQ

What is the primary disadvantage of a construction permanent loan?

Higher interest rates However, since the home is in the construction phase, the lender is taking on additional risk. Because of the increased risk, borrowers typically have to pay higher interest rates on construction-to-permanent loans than on a traditional mortgage.

What happens at the end of a construction loan?

After construction concludes, you’ll secure a separate traditional loan. Construction–to–permanent loan: In this situation, you’ll obtain only one loan. At first, the loan pays for the home’s construction costs. Then, after you move in, the loan converts into a permanent loan.

What is a permanent loan taken out after the construction loan?

Construction-to-Permanent (C-to-P) financing allows lenders to replace the interim construction financing borrowers use to construct a new residence with a long-term mortgage that can be delivered to Fannie Mae. We’ve compiled some of our most common questions on the offering below.

Is a construction loan harder to get than a mortgage?

In general, it is harder to qualify for a construction loan than for a traditional mortgage. Most lenders require a credit score of at least 680 — which is higher than what you’d need for most conventional, VA and FHA loans.

How long does a construction loan last?

The amount you borrow during this phase covers the costs associated with the land, materials, and labor needed to build the home. The construction loan phase typically lasts somewhere between six months and two years. After the construction process has ended, the loan is then converted into a permanent mortgage.

How does a construction loan work?

– **Funding Phases**: The lender releases funds at various stages of the project, usually directly to the contractor.These phases align with project milestones. – **Interest and Repayment**: Construction

How do construction to permanent loans work?

Once the home is built, you’d take out a separate mortgage to finance it. Construction to permanent loans eliminate the need for two different loans. Instead, you get a single loan to purchase the land and build the home that will convert to a permanent mortgage when construction is complete.

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.