If you’re dreaming of building a new home from scratch, then a construction-to-permanent loan might just be the perfect solution for you. These loans not only cover all the expenses involved in constructing your dream house, but they also seamlessly convert into a conventional mortgage once the construction is complete.
How do construction-to-permanent loans work?
Construction-to-permanent loans operate in two distinct phases. During the construction phase, which typically lasts between six months and two years, you’ll only need to make interest payments. The loan amount during this phase covers the costs of land, materials, and labor required for building your home. Once the construction is finished, the loan converts into a permanent mortgage, and you’ll start making ordinary monthly payments that include both principal and interest.
Getting approved for a construction-to-permanent loan involves an application process similar to that of a traditional mortgage. You’ll need to provide proof of income, credit history, and other relevant financial information to the lender. Additionally, you’ll have to submit the blueprints, design, and price of the home, along with the builder’s contract. The approval process may take longer as the bank reviews construction plans and contracts. Once approved, you can access the funds and start paying the contractors for different stages of the construction.
Pros of using construction-to-permanent loans
Consider these advantages when weighing your financing options for building your home:
Pay less in closing costs
With a construction-to-permanent loan, you only have to pay closing costs once. If you were to take out a separate construction loan and then a conventional mortgage, you would end up paying closing costs twice, potentially costing you thousands of dollars.
Only draw funds as needed
Construction-to-permanent loans allow you to draw funds only when necessary to pay the contractors. This means you’ll pay interest only on the funds you actually use during the construction process.
Interest-only payments during the construction phase
During the construction phase, borrowers using a construction-to-permanent loan only need to make interest payments. This helps reduce the overall cost while your home is being built, allowing you to save money until you can move in.
Cons to using construction-to-permanent loans
While construction-to-permanent loans have their benefits, they may not be the best fit for everyone. Consider the following drawbacks:
Higher interest rates
Construction-to-permanent loans typically have higher interest rates compared to traditional mortgages. This is because lenders assume additional risk during the construction phase of the loan. However, the advantage of converting to a fixed-rate mortgage after construction is complete can offset the higher interest rates.
Larger down payment required
Due to the increased risk involved in a new construction project, lenders usually require a down payment of at least 20% for construction-to-permanent loans. In contrast, if you were purchasing an existing home, you might be eligible for loans with a down payment as low as 3.5%.
How to get a construction-to-permanent loan
Before construction can begin, several steps need to be completed:
1. Choose a builder
Start by selecting a reputable builder for your project. Ask friends and family for recommendations or use online resources like Angi.com to find potential builders. Look for positive reviews, ask for references, and review their past work.
2. Finalize your construction plans
Before applying for the loan, ensure that your home design, construction plans, and budget are finalized.
3. Choose a lender
Research and speak with multiple lenders to find the one offering the most favorable terms for your construction-to-permanent loan.
4. Apply for a loan
Submit an application to your chosen lender, providing proof of income, tax returns, bank statements, and other financial documents. Additionally, include building plans and estimated costs for each phase of the project.
5. Purchase insurance
During the construction phase, lenders usually require you to have builder’s risk insurance to protect their investment and yours.
Requirements to be eligible
To be approved for a construction-to-permanent loan, lenders generally expect the following:
- Good to excellent credit score (minimum 680)
- A reliable and experienced builder
- Sufficient income to repay the loan
- Low debt-to-income ratio (DTI) (typically no higher than 45%)
- Minimum 20% down payment
- Detailed project budget and plans
How to convert a construction-to-permanent loan
There are several options to convert your construction loan into a permanent loan, depending on your lender:
1. Single closing transaction
Some lenders offer a single closing transaction where you complete the application and closing process for both the construction and permanent loans simultaneously. This streamlines the process and reduces costs.
2. Two-closing transactions
If interest rates are falling, a two-closing transaction might be an option. You would apply for and close a construction loan, and then pay it off using a traditional mortgage once construction is complete. This can take advantage of lower mortgage rates but has its risks if you don’t qualify for a mortgage later.
3. Limited cash-out refinance
Instead of paying the second set of closing costs out of pocket, you can opt for a limited cash-out refinance. This allows you to include the closing costs in your permanent loan amount.
Alternative types of construction-to-permanent loans
If you’re interested in exploring other loan options, consider these alternatives:
USDA combination construction-to-permanent loan
For those building in rural areas with a population of 35,000 or less and within USDA income limits, a USDA combination construction-to-permanent loan might be suitable. It requires no down payment and has a minimum credit score requirement of just 640.
VA construction loans
Active or retired military personnel may qualify for a VA construction loan, which also does not require a down payment. The minimum credit score for this loan is typically 620.
FHA one-time close construction loans
If you have a small down payment and less-than-perfect credit, an FHA one-time close construction loan could be an option. It requires a credit score of at least 580 and a down payment of at least 3.5%.
Frequently asked questions (FAQs)
Here are the answers to some commonly asked questions about construction-to-permanent loans:
What is a construction-to-permanent loan vs. a construction loan?
While both provide financing for building a new home, a construction-to-permanent loan combines both the construction loan and permanent loan into a single transaction. This eliminates the need for a separate permanent loan and associated closing costs.
Construction-to-permanent loan vs. HELOC
Construction-to-permanent loans and HELOCs both let you draw funds and pay interest during the draw period. However, a HELOC is based on the equity in an existing home and cannot be used for constructing a new home.
Can I use excess funds for home furnishing?
No, construction loan funds are typically paid directly to the builder. If there are leftover funds after construction, they cannot be used for home furnishings. You may need to cover those costs separately, such as through a personal loan or line of credit.
Can I use it for the design phase of home building?
Construction-to-permanent loans do not cover the design phase of home building. Design costs need to be paid out of pocket.
Can you lock in the interest rate on a construction-to-permanent loan?
Yes, when you close on your construction-to-permanent loan, you can lock in your interest rate. This protects against rate increases during the building process.
What is the typical interest reserve in a construction loan?
Lenders typically set up an interest reserve account for construction loans to pay for the interest on the amount drawn. The exact amount depends on factors such as loan amount, outstanding balance percentage, interest rate, and estimated construction duration.
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Note: The content in this article is for informational purposes only and should not be taken as financial advice. Please consult with a professional before making any financial decisions.