What Is a Construction-to-Permanent Loan?

What Is a Construction-to-Permanent Loan?

A construction-to-permanent loan combines your construction financing and a mortgage into one loan. Also called single-close loans, this financing option helps you save money on closing costs by wrapping both the construction loan and mortgage into a single closing.

By contrast, a traditional construction loan only covers the cost of land, materials and building your home. Once the project is complete, you'd need to take out a separate mortgage to pay off the construction loan and finance the home.

A construction-to-permanent loan can save time and streamline your homebuilding and financing costs since it can be used to finance the land, building process and the permanent mortgage.

How Does a Construction-to-Permanent Loan Work?

A construction-to-permanent loan may be structured as a conventional, Federal Housing Administration (FHA) or Veterans Affairs (VA) loan from the start. Once approved, the loan initially works to fund the construction phase. Instead of distributing the funds in one lump sum, your lender will release them in installments, or "draws," to pay for the land, materials, permits and other construction costs. Your lender may require inspections to confirm each phase of the work is finished before releasing funds.

During construction, you'll be expected to make interest-only payments based on the drawn amount. Once the project is complete and the lender is satisfied with final inspections, the loan converts to a standard mortgage. At that time, you'll start making your regular monthly payments, including both principal and interest.

What Are the Requirements for a Construction-to-Permanent Loan?

The requirements for a construction-to-permanent loan are usually stricter than those for a regular home loan. That's because the home doesn't exist yet, so there's no collateral until it's built. Here are the main requirements you'll need to meet:

• Down payment: While conventional mortgages can often be obtained with as little as a 5% down payment—or even lower with an FHA or VA loan—construction-to-permanent loans typically require much higher down payments. You'll usually need to put down at least 20% of the total project cost, or even up to 30%, depending on your creditworthiness.
• Credit score: You'll generally need a FICO^® Score^☉ of 670 or higher to qualify for a construction-to-permanent loan. The higher your credit score, the better your chances of approval and receiving favorable loan terms.
• Debt-to-income ratio: Lenders evaluate your debt-to-income ratio (DTI) to see if you have room in your budget to take on a new mortgage loan payment. For construction-to-permanent loans, a DTI ratio of 43% or lower is typically required, meaning your total monthly debt payments should not exceed 43% of your gross monthly income.
• Proof of income: You'll need to provide your lender with recent pay stubs, tax returns or W-2 form to verify you have a steady income. Your lender wants to know you can make payments while the home is being built and over the duration of your loan term.
• Lender-approved builder: Most lenders require you to work with a licensed, insured and experienced builder they've reviewed and approved.
• Construction blueprints: Your lender will also want to see your project blueprints before approving the loan. You may also need to provide them with a detailed budget and a draw schedule.

Pros and Cons of Construction-to-Permanent Loans

A construction-to-permanent loan can simplify your financing and save you from a second closing, but there are a few drawbacks you must consider first.

Tip: When comparing lenders, ask about their approval process for releasing each funding installment. Understand if your lender needs to review documents and approvals at each phase, it could lead to project delays.

Should You Get a Construction-to-Permanent Loan?

A construction-to-permanent loan could be a smart option if you're looking for the convenience and cost savings of a single-close home loan. While they're not ideal for everyone, they can be a great fit in these situations:

• You have a strong construction plan. You'll need to provide your lender with detailed blueprints and a realistic budget and timeline before they approve the loan. This not only helps you qualify, but also helps ensure the home is built to your vision and expectations.
• You want to avoid multiple closings. A single-close loan saves you money by not having to pay a second set of closing costs.
• You have a solid financial profile. Not only do you need good credit and finances to qualify for a construction-to-permanent loan, but you'll also need enough income to cover your current housing costs and interest-only payments during construction. You'll also want some wiggle room in your budget in case you face delays or cost overruns.

How to Apply for a Construction-to-Permanent Loan

Applying for a construction-to-permanent loan can be trickier than applying for a traditional one. Here's a breakdown of the application process to finance both your new home build and the permanent mortgage.

1. Get Preapproved

It's generally recommended to get preapproved for a mortgage to find out how much you'll qualify for and set your budget accordingly. Check qualifications and loan terms with your current bank, and compare them to offers from other financial institutions, including credit unions and online lenders.

Tip: A mortgage calculator can be helpful to show you what your monthly post-construction payments might look like at specific loan amounts and interest rates.

2. Choose a Builder

Research local builders to find a reputable, licensed builder with experience building homes like the one you're envisioning. They should also be able to meet any builder requirements your lender has.

Get recommendations from friends, read online reviews and check builder references to find the right company for the job. After all, this is the person you're entrusting to manage the project and bring your dream home to life.

3. Submit Construction Plans and Contract

You'll need to supply your lender with financial documents, a construction budget, a project timeline and a signed contract with your builder. These documents outline the building plans and costs, which your lender will review to decide whether to approve the loan.

4. Appraisal and Underwriting

Once your documents are submitted, your lender begins the underwriting process to confirm your finances and project details. They'll also assess their risk and decide whether the project is realistic. An appraisal will be arranged to estimate the value of the land and your future home based on your construction plans and budget.

Learn more: How Long Does Mortgage Underwriting Take?

5. Loan Approval and Closing

Depending on your lender, you may be granted a conditional loan approval before the appraisal. Once the appraisal is complete, which could take two to three weeks, the lender will work to close the loan by finalizing the loan amount, setting your interest rate and calculating how much cash you'll need at closing, among other tasks. Your builder will also provide a final statement showing any costs they've already paid and what deposits are still needed. Once everything is in order, you'll close on the loan and sign the final documents to move forward with construction.

Learn more: The Complete Guide on How to Get a Mortgage

Alternatives to Construction-to-Permanent Loans

If you don't qualify for a construction-to-permanent loan, you might consider the following alternatives:

• Cash-out refinance: This loan replaces your current mortgage with a larger one, ideally at a lower interest rate. You receive the difference between the two mortgages, minus closing costs, in cash.
• VA construction loans: VA construction loans are available to eligible veterans with both one-time and two-time closing options. It's a good idea to compare your options with multiple lenders. According to Veterans United, true 0% down VA construction loans are rare, as many lenders don't fund the initial build. Instead, they offer a refinance option that converts a completed construction loan into a permanent VA mortgage.
• FHA construction loans: The Federal Housing Administration insures construction-to-permanent loans that combine the build and mortgage phases with a single closing process. These loans may offer more lenient eligibility requirements, such as a 3.5% minimum down payment for creditworthy borrowers and a minimum credit score of 640.
• Home equity loan: This loan allows you to tap into your home's equity for a lump-sum amount that you must repay at a fixed rate over your loan term.
• Home equity line of credit (HELOC): Similar to a home equity loan, this revolving line of credit is secured by your home's equity. But a HELOC is a credit line, meaning you can draw from it as needed like a credit card at a variable interest rate for a certain time period.

Frequently Asked Questions

Resolving Credit Issues May Improve Your Loan Approval Odds

Whether you get a construction-to-permanent mortgage or a traditional one, good credit can help you qualify and receive favorable terms. The two best ways to build and maintain good credit are to make debt payments on time and keep your overall debt levels low. These factors make up 35% and 30% of your FICO^® Score, respectively.

Another way to score a quick credit win is to resolve issues on your credit report that may be dragging down your score. Start by checking your Experian credit report for free and reviewing it for any inaccuracies. Remember, you have the right to dispute any information on your credit report you believe to be false or fraudulent.