How Do Construction-to-Permanent Loans Work?

Construction-to-permanent loans allow home buyers to buy a plot of land, build their dream home, and then pay off the purchase through one loan. This financing option—also known as a single-close loan—is perfect for borrowers looking to cut down on the number of steps it takes to build a home. Here’s how this loan product works. 

What is a Construction-to-Permanent Loan?

Instead of needing two loans—one to buy the land and one to finance the build—borrowers can roll both pieces of the building puzzle into a construction-to-permanent loan. 

This loan product prevents borrowers from taking out both a land loan and a construction loan, which can be expensive and difficult to pay down at the same time. Keep in mind that this type of loan is best for home buyers who want to build a custom home on a chosen plot of land using contractors they pick. 

How Do Construction-to-Permanent Loans Differ From Other Loan Options?

Unlike other types of loans, a construction-to-permanent loan works like a line of credit. Once your trusted lender approves your loan amount, the funds are deposited into an account that you can draw on every step of the building process. Then, once construction is complete, the loan converts into either a 15- or 30-year fixed rate mortgage. 

For example, if your lender approves a construction-to-permanent loan for $300,000, you can spend $50,000 securing the land from the seller and then use the remaining $250,000 to pay for the building contractor and home construction. This option differs from other loan products because it doesn’t require home buyers to apply for and take out two separate loans.

Benefits of Construction-to-Permanent Loans

Now that we understand how this type of loan works, let’s review its benefits.

• Convenience: There’s no denying that it’s easier to apply for and manage one loan instead of two. This method will save you time and paperwork.

• Only accumulating interest during construction: You’re only charged interest on the portion of the funding that’s used to build the property. Using the example from above, you’d only pay interest on the $250,000 used by the builder for the first 18 months (or until the property is complete). 

• Save money on application and other fees: Since you only need one construction-to-permanent loan instead of two separate loans, you avoid paying two rounds of application, settlement, and other fees.

Drawbacks of Construction-to-Permanent Loans

It’s not all good news when it comes to this type of financing. Let’s take a look at its drawbacks.

• Higher interest rates: Due to the increased risk—there’s no house for a lender to leverage if you default on your loan before building is complete—you’ll often pay a pretty penny for the convenience. You can expect to pay higher fixed interest rates during the construction period.

• Bigger down payments: To prove that you’re qualified to take on this type of loan, most lenders require a down payment of at least 20%, which is higher than the threshold for other loans.

• Stricter qualifying guidelines: You can expect to provide additional documentation, such as written contract with contractor, specified plans for the home build, proof of insurance coverage for you and the builder, and written requests for each withdrawal from the loan.

• Penalty fees: If you don’t complete your home’s construction by the anticipated date, the lender could charge you a penalty fee for not adhering to the deadlines.

How to Apply for a Construction-to-Permanent Loan

Since this type of loan is as unique as the home you’re hoping to build, you’ll likely need to find a lender that specializes in new-construction loans. You should prepare to submit more paperwork than you would for a traditional construction or land mortgage. You’ll likely have to provide building plans, approvals from local municipalities, and documents from your builder before you can get the lender’s approval. 

To make the loan application process as seamless as possible, scout out the land you’re looking to buy and get a complete estimate from a reputable builder or architect. This estimate should include the costs, plans, and permits required for all of the proposed work. Reach out to your loan lender for specific application and qualification requirements.