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 land, materials, permits and more. Many lenders offer construction-to-permanent loans, but you’ll most often find them at a bank or with a lender specializing in construction financing.

What is a construction-to-permanent loan?

A construction-to-permanent loan — also known as a one-time, single-close or construction-perm loan — is a type of mortgage for those building a new construction home. Once the home is built, the loan converts into a traditional mortgage, usually with a 15- or 30-year term.

A construction-to-permanent loan saves you time and money by streamlining the process of building a new house. Since this loan type provides the financing for the home’s construction and then converts to a mortgage, you won’t have to pay two sets of closing costs or close on two separate loans as compared to getting a construction-only loan.

How does a construction-to-permanent loan work?

Construction-to-permanent loans function in two phases: construction and post-construction. During the construction phase, the lender authorizes payments, or draws, to cover the cost of land, materials, labor, permits and other expenses. The lender works closely with an inspector to ensure the construction continues on schedule and on budget.

The construction phase typically lasts about one year but can vary depending on your lender, permitting, scheduling and the project’s size. During this time, you might only need to make interest payments. Once construction is completed, the loan converts into a traditional mortgage, and you’ll start repaying the mortgage principal and interest.

Construction-to-permanent loan example

Imagine you decide to build a new home. You want to purchase a parcel of land that costs $50,000, and you estimate that the house will cost $350,000 to build. In total, you would need $400,000 of financing to cover the cost of buying the land and building the home.

Construction-to-permanent loans typically require a 20 percent down payment, which in this case, would be $80,000. To borrow $400,000 over a 30-year period with a 7 percent interest rate, your monthly payment in principal and interest would be about $2,129. However, you might be able to pay only interest during the construction phase.

Construction-to-permanent loan eligibility requirements

Since there’s more risk involved with building a home, lenders typically have more stringent requirements for construction-to-permanent loans. Conventional construction-to-permanent loans can have fewer restrictions than government-backed loans, however. Along with having your finances in order, you’ll need to submit detailed plans and work with approved professionals. Here are the typical requirements:

• Down payment: 20 percent
• Credit score: 680
• Debt-to-income (DTI) ratio: 45 percent or below to boost your application
• An estimated appraisal: An appraiser will need to determine the home’s estimated completed value
• Project approval: The lender needs to approve your budgets, schedule, blueprints and more
• Architect and contractor approval: You’ll need to hire licensed, professional builders and submit copies of their licenses, certificates and/or resumes to your lender

Pros and cons of construction-to-permanent loans

Construction-to-permanent loans have benefits as well as drawbacks. Here are the major ones to consider.

Pros of construction-to-permanent loans

• Only one set of closing costs: Instead of taking out a construction loan and then a mortgage, a construction-to-permanent loan combines the two, which limits your closing costs.
• Ability to draw funds as needed: Construction-to-permanent loans pay out to builders as the project progresses.
• Interest-only payments during construction: Many construction-to-permanent loans only require you to make interest payments during construction. This can make budgeting easier, especially if you have rent or another mortgage to pay while your new home is being built.

Cons of construction-to-permanent loans

• Bigger down payment than other mortgages: Conventional construction-to-permanent loans are riskier for lenders because the home that normally serves as collateral isn’t built. Because of this, you could be required to make a higher down payment.
• Cost overruns: If the project goes over budget (and most do), the loan amount might not cover it. In this case, you’d have to pay out of pocket or get another loan to cover the additional costs.
• Higher interest rates: Construction-to-permanent loans are generally more costly than conventional mortgages. What’s more, the interest rate on the construction portion of the loan might exceed the permanent mortgage rate later on.
• More paperwork: Because a construction-to-permanent loan combines a construction loan with a mortgage, you’ll need more documentation than a traditional mortgage. That means submitting blueprints, a budget and licenses for contractors.
• Builder must be approved: The lender you want to work with must approve your contractor, so you might not be able to work with whoever you want.
• Time limit for building: A construction-to-mortgage loan has a time limit for building the home. Usually, the home must be built within one year, but you might be granted a 6-month extension.

How to apply for a construction-to-permanent loan

Applying for a construction-to-permanent loan involves more steps than applying for a standard mortgage. Here’s what you’ll need to do to get started:

1. Get preapproved: Like with other types of mortgages, it’s a good idea to get preapproved for a construction-to-permanent loan. Getting preapproved will tell you how much funding you can qualify for based on factors like your credit score and DTI ratio.
2. Find a builder and an architect: Research potential builders and architects, read up on their reputations and ask for references. Then, set a budget and a timeline and finalize the home’s design.
3. Get a lender: Consider at least three offers from different lenders, comparing their rates as well as their experience funding construction-to-permanent loans. Read consumer reviews of each lender, as well. While your rate is a significant factor, you’ll also want to know about the lender’s application process and customer service. Once you decide on one, you’ll need to apply for the loan, submitting paperwork on income, assets, debts and more.
4. Buy insurance: Your lender may require you to buy builder’s risk insurance or new construction insurance to cover the home while it’s being built.

Construction-to-permanent loan FAQ

• What are alternatives to construction-to-permanent loans?

  Alternatives to construction-to-permanent loans include:

  • • FHA construction loans: For as little as 3.5 percent down, you can get a construction loan insured by the Federal Housing Administration (FHA). These come in the form of a construction-to-permanent loan and the 203(k) loan, which is a renovation loan you can use to rehab an existing home.

  • • VA construction loans: For eligible veterans, members of the armed services and their surviving spouses, construction loans guaranteed by the Department of Veterans Affairs (VA) offer an option to build a home with no down payment required.

  • • Home equity line of credit (HELOC): If you already own a house, you can tap into your home equity with a HELOC. With enough equity, you could use a HELOC to fund another home’s construction. However, keep in mind you’ll need to use your home as collateral and pay out of pocket for any construction costs not covered by the HELOC.

  • • Cash-out refinance: Similar to a HELOC, a cash-out refinance will let you tap your home equity to construct another home. Unlike a HELOC, it replaces your current mortgage with a new mortgage for a new amount and new rate.

• What is the difference between a construction-to-permanent loan and a construction loan?

  A construction loan only finances the construction of the home. Once the home is built, you’ll need to either repay the loan in full or take out a separate mortgage. A construction-to-permanent loan bundles the construction loan and the mortgage.

• How does the disbursement of funds work during the construction phase of a construction-to-permanent loan?

  The lender pays the builder out in disbursements that are called “draws.” The lender and builder agree upon a draw schedule for these payments, and before making the payments, the lender works with an inspector to see that the agreed-upon work has been done.

• Can I use a construction-to-permanent loan for major renovations or additions to an existing property?

  Construction-to-permanent loans are only for building new properties. There are different loan options for renovating, including:

  • A personal loan: Some personal loans for this purpose are capped at $35,000, though certain lenders may offer more. When compared to mortgages or home equity loans, personal loans are financed faster. However, they generally come with higher interest rates.
  • A home equity loan or line of credit (HELOC): If you own a home with significant equity, you can tap into that equity with a home equity loan or a HELOC.
  • An FHA 203(k) mortgage: If you’re buying an existing home that needs a significant amount of work, a 203(k) mortgage can help you finance the home purchase as well as the renovations.

• What happens if the construction phase exceeds the estimated timeline outlined in the loan agreement?

  If you need more than 12 months to complete your home construction, the lender may grant you a 6-month extension. However, the construction phase cannot take longer than 18 months in total. If more time is needed, the lender will likely convert the construction-to-permanent loan to a two-closing transaction, meaning you will close on two loans: one for the interim construction and another for the home’s long-term financing.