The real estate market is aging, with over half of owners living in homes built before 1980. That can make finding your dream house challenging unless you hire a professional to build it. As stressful as that sounds, construction-to-permanent financing streamlines the process.
Learn more about this type of loan to see if it is right for you. If so, you can work with a lender to obtain financing.
Construction-Only vs. Construction-to-Permanent Financing
While there are various construction loans, you will most likely decide between construction-only or construction-to-permanent financing. Both options have benefits, restrictions, and best case uses.
Construction-Only Loans
Construction-only financing is a short-term loan issued for up to 18 months. Borrowers draw on the funds to pay for construction costs and make monthly interest payments on the amount they have used.
Borrowers must pay the loan in full at the end of the term or apply for an end loan to convert the debt into a traditional mortgage.
Although this option may appear to have lower upfront costs, by separating the two loans, borrowers must go through closing and pay all associated fees twice. Additionally, some borrowers are not approved for a second loan, forcing them to find another way to pay off the construction loan.
Construction-to-Permanent Financing
While construction-to-permanent loans have two phases, borrowers only close on the loan once. At first, the loan works just like a construction-only loan. Borrowers draw on funds to cover expenses and pay interest on all used funds.
However, borrowers do not have to pay the construction loan off at the end of 18 months. Instead, the construction loan becomes a traditional mortgage, giving borrowers 10-30 years to pay off the debt.
This option provides for a lock-in of the rate, long term planning, and a simplified process by avoiding the need to qualify for a new loan.
Expenses Covered By Construction-to-Permanent Financing
Construction-to-permanent loans are used to pay for construction-related expenses. Typical expenses include the following:
Cost of the land- Materials
- Labor
- Permits
Borrowers cannot use the funds to pay for furniture or other expenses unrelated to the construction.
Requirements for Obtaining a Construction-to-Permanent Loan
In a traditional mortgage loan, lenders are able to minimize risk by using the existing property as collateral. Thus, if the borrower defaults, the lender can take steps to seize the home.
Without an existing home, construction loans are far riskier for banks requiring them to have rigorous requirements in place.
Borrowers need to first demonstrate that they can repay the loan. To ensure borrowers meet the criteria, lenders consider assets, income, employment history, debt-to-income ratio, and other factors.
Also, most lenders will not consider applicants with credit scores below 680, and some require a score of 700 or above. The increased risk also impacts the down payment amount for construction-to-permanent financing.
While getting a traditional mortgage for as little as 5% down is possible, lenders typically require at least 20% for construction loans. In fact, the down payment can be as much as 30% for borrowers with weaker credit or less income.
Banks also expect borrowers to choose reputable builders before approving them for construction loans. Due to the risk, lenders want to work with builders who have proven that they build high-quality homes within the predetermined timeline.
Finally, many lenders review an estimated appraisal before approving loans. They want to know how much the home will be worth once completed before extending a financing offer.
Releasing the Funds
Upon approval, borrowers can withdraw funds to pay for construction costs. The lender may visit the site to ensure milestones are completed before dispensing the money.
Because the approval amount is based on the estimated construction costs, the project may end up under or over budget. If the project is under budget, the lender will take back the excess funds, and the borrower will not be responsible for repaying that amount.
However, the borrower cannot apply to increase the amount of the construction-to-permanent loan if the builder exceeds the budget. Instead, the borrower can explore other financing options with the lender.
Rates for Construction-to-Permanent Loans
Construction-only loans typically have variable interest rates, while construction-to-permanent loans are at a fixed rate. This means borrowers pay the same interest rate during construction and the traditional mortgage.
Rates vary between lenders, but construction-to-permanent loans typically have a slightly higher interest rate when compared to traditional mortgages. However, the higher rate does not necessarily mean borrowers pay more throughout the loan.
Borrowers lock in the rate when closing the loan, meaning they are not impacted by interest rate increases during or after construction.
Also, borrowers only pay for closing once instead of twice, saving them thousands of dollars. Thus, the higher interest rate is not a reason to avoid construction-to-permanent loans.
Find Out If You Qualify for Construction-to-Permanent Financing
Building a home is exciting, but you must first secure the financing. While some large lenders fail to consider the people behind the applications, Woodsboro Bank takes a personal approach.
We work directly with applicants to help them secure financing for projects big and small. Contact Woodsboro Bank today to learn more about construction loans that may be right for your new home.