While existing at a 13-year low in 2023, sales of newly constructed homes exceeded industry expectations. This change in the homebuying landscape has led to increased interest in construction-to-permanent loans and questions about how they compare with traditional mortgages.
Find out how the two differ to determine which loan option is right for your needs.
Overview of Construction-to-Permanent Loans
Construction loans cover the costs of building a new house, such as the materials, labor, and permits. Some borrowers get construction-only loans that must be repaid at the end of the term.
As short-term loans, the full payment is generally due within a year of obtaining financing, so many borrowers apply for traditional mortgages once the construction is finished. If approved, they must close the first loan and pay the associated fees.
Those who want to streamline the process can get a construction-to-permanent loan instead. Also referred to as one-time close construction loans, these loans automatically convert into traditional mortgages after construction completion.
Many borrowers prefer this to construction-only loans since they don’t have to close twice.
How Construction-to-Permanent Loans Differ From Traditional Mortgages
Even though a construction-to-permanent loan converts to a traditional mortgage, the two are different. The most significant difference concerns the purpose of the loan.
Conventional mortgages pay for existing homes, while construction-to-permanent loans fund construction before turning into traditional mortgages. The following are some other differences between the two.
Credit Requirements
Most lenders require that borrowers have a credit score of 620 or above to secure a traditional mortgage, but that increases to 680 or higher for a construction-to-permanent loan.
The likelihood of getting approved for a construction loan increases if your credit score is at least 700 and you have a low debt-to-income ratio.
Interest Rates
Since a construction-to-permanent loan isn’t secured by existing real estate, the interest rate tends to be higher than a traditional mortgage. Rates differ depending on the lender and borrower’s creditworthiness.
On average, you can expect to pay a percentage point higher in interest for a construction loan. This doesn’t necessarily mean that you’ll pay more overall, though.
If you were to get a construction-only loan followed by a separate mortgage, you’d have to close twice. Closing fees typically range from 2 - 6% of the loan amount, making a construction-to-permanent loan a sound financial decision when building a new home.
Down Payment
Lenders also mitigate risk by requiring a large down payment when approving a construction-to-permanent loan. In most cases, borrowers must put 20% or more down to secure the loan, compared to 3 - 5% for a traditional mortgage.
The lender might reduce your down payment if you own the land you’re building on outright since it can be used as collateral. Additionally, you can use equity in the land for the down payment.
Paperwork Requirements
Lenders require an appraisal before approving traditional mortgages. While an estimated appraisal is needed for construction-to-permanent loans, you’ll also need additional paperwork. You have to prepare and provide the blueprints, contractor’s licenses, and estimates.
Repaying the Loan
Lenders disperse traditional mortgages in lump sums, and you’ll immediately make payments on the interest and principal. On the other hand, construction-to-permanent loans aren’t distributed all at once.
Instead, you’ll draw on the loan when you need to pay construction costs and will only be responsible for interest payments during the project. Once construction is completed, you’ll start paying interest and principal on the mortgage.
Potential Cost Overruns
The home’s price is already established when obtaining a traditional mortgage loan, so you know exactly how much to borrow. Unfortunately, construction-to-permanent loans are based on cost estimates, and these projects often exceed budgets.
Since these loans usually can’t be modified, borrowers might have to take out another loan to finish the project.
Inspection Requirements
Lenders generally require an inspection before approving traditional mortgages, but that’s not always required. However, inspectors and appraisers are involved in projects funded through construction loans.
Most lenders require at least four inspections during construction, but can be as many as six or more.
Land Ownership
You must own or be purchasing the land you’re building on to obtain a construction-to-permanent loan. If you don’t already own it, you can add the cost to the construction loan.
This is not the case for a traditional mortgage loan in which the cost of the land is already factored into the cost of the home.
Let Woodsboro Bank Help You Choose a Loan
Real estate is a significant investment, and choosing the right type of loan is vital. As a local bank, Woodsboro Bank truly cares about the members of the community and provides personalized support and solutions for its clients.
Contact Woodsboro Bank at 301-898-4000 to discuss your needs and loan options. With the help of a professional loan officer, you can be one step closer to securing financing for your dream home.