Building a Home From Scratch with a Construction-to-Permanent Loan – Pros & Cons

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If you want to build a home from the ground up, your first move is to purchase a plot of land. 

Then you can begin the construction process. That would normally entail getting one loan to cover the purchase of the land and costs of construction, and a second loan for the mortgage on the finished residence.

But you can save time and money by pursuing a construction-to-permanent loan. This option simplifies the financing process by providing one loan and one closing transaction.

There are some caveats to keep in mind though: You may end up paying a higher interest rate, or a larger down payment may be required. And your lender may have additional requirements and restrictions.

Determine if a construction-to-permanent loan is right for you by learning more about what’s involved.

What Is a Construction-to-Permanent Loan?

A construction-to-permanent loan, also called a single-close loan, is a special loan used to finance the cost of buying land, building a home on it, and later serving as the mortgage on the home once it’s finished being built. This kind of loan is ideal for borrowers who want to build a custom home from scratch on a chosen lot using contractors they pick.

Normally, you’d need two separate loans for these purposes: a construction loan to buy the land and build a home on it, and a separate mortgage loan to finance the finished home. A construction-to-permanent loan accomplishes both goals. Loan funds are used to pay for the lot and building costs and once construction is completed, the loan converts to a fixed-rate permanent mortgage loan with a term of 15 to 30 years — whichever you choose.

Here’s an example of how a construction-to-permanent loan works and how it can simplify the financing process. Mark and Cindy want to build a completely custom home on a lot for sale. They enlist the help of an architect and consult with different contractors to get an idea of how much a custom home will cost to build. Armed with an initial cost estimate, which they’ve deemed is within their budget Cindy and Mark apply for a construction-to-permanent loan from a trusted lender. After providing careful documentation, including confirmation that the planned home will conform with local building codes and regulations, their loan is approved. Now, they can purchase the lot and pay their contractors in stages as the project dictates without having to apply for multiple loans.

Advantages of a Construction-to-permanent Loan

There are several upsides to a construction-to-permanent loan. For one, this kind of loan works like a line of credit in that you’re allowed to draw exactly the amount of money you need at the time you need it. 

Another benefit is that you’re charged interest only on the amount you draw on during the construction phase. While your home is being built, you’ll only be making interest payments on the construction part of the loan — for up to 18 months. So your payments will be lower during this period than if you had taken out a different kind of loan. That kind of flexibility comes in handy, especially if the construction is taking longer than expected.

Perhaps best of all, you don’t have to apply, qualify, complete paperwork, or pay closing costs for two different loans. That can save you time as well as money otherwise spent on separate application and settlement fees.Additionally, for both the construction phase and the mortgage phase, “you can usually lock in a fixed interest rate up to 18 months in advance,” says Sheryl Starr, a real estate attorney and managing partner with Bernkopf Goodman LLP in Boston. “This can protect against rising interest rates.”

Disadvantages of a Construction-to-Permanent Loan

This loan type, while it offers convenience, it’s not without drawbacks. Construction-to-permanent loan lenders usually charge higher fixed interest rates, especially during the construction phase. That’s because the lender considers these loans riskier because it’s funding the land, the construction, and the mortgage on the finished home, and it may take up to 18 months before you switch from making interest-only payments to principal and interest payments on your mortgage. Your lender may charge the same fixed interest rate for both phases or reduce the fixed interest rate once your loan converts to a permanent mortgage loan.

You may have to make a larger down payment, too – often at least 20% – to get this loan. Other loan programs may require a lower down payment.

Also, your lender may require additional documentation for this loan, according to Starr, such as:

  1. A written contract with a licensed general contractor along with complete plans and specifications for your new home.
  2. Proof of builder’s risk insurance and other insurance coverage protecting the property during construction.
  3. A prepared statement from your contractor every time money is requested, indicating work that has been completed, how much has been paid so far, how much is requested for that month, and how much work remains before construction is finished.

Your lender may also insist on an inspection every time you want to draw more loan funds, — and you’ll have to pay for that each time. Your lot and finished home may require separate appraisals you must pay for, as well. Also, depending on the lender and the terms of your loan, you may be charged a penalty fee if the home takes longer to build than anticipated (such as longer than one year) or if you try to pay off the loan or refinance it early.

Lastly, if the amount of your loan is insufficient to pay the entire cost of construction, you’re responsible for paying for the rest out-of-pocket.

How to Determine if Your Property is Eligible

To qualify for a construction-to-permanent loan, most lenders stipulate that the home must be an owner-occupied primary residence or a second home. Additionally, the home has to be a single-unit, single-family, detached residence. That means attached homes like townhomes, condominiums, and multifamily properties are not eligible.

A construction-to-permanent loan through Fannie Mae or Freddie Mac can also be used to finance manufactured homes.“To determine if your property is eligible, your best course of action is to connect with a loan advisor to discuss the project upfront,” suggests Paul Buege, president and COO of Inlanta Mortgage in Pewaukee, Wisconsin.

How to Draw on Your Loan

The balance of your loan is paid out in increments to your contractors throughout the building phase. These installment payments are called “draws.” Before closing on your loan, your lender will create a draw schedule.

Your lender or builder “will perform inspections during the construction phase, submit a detailed report of the work completed so far, and request additional funds to be disbursed,” Buege explains.

Typically, the borrower isn’t involved in the draw process, Buege adds.

What Are the Upfront Costs?

As with any construction or home loan, a single-close loan has associated costs you’ll need to pay upfront. These include:

  • The minimum down payment your lender requires – often 20% of the total amount borrowed. 
  • Your lender may also include financing costs like a loan application fee as well as closing costs.

Once your loan closes and you begin drawing funds from your loan to cover construction expenses, you’ll start making interest-only payments on the amounts you draw.

Where Can I Find a Construction-to-permanent Lender?

Construction-to-permanent loan lenders can be found at most traditional lending institutions online or at brick-and-mortar locations.

When shopping around for lenders, you need to specifically seek out or ask for this type of loan, notes Daniel Hill, CFP and president of Richmond, Virginia-headquartered Hill Wealth Strategies.

Then, be prepared to provide specifics to the lender, including “where your home will be built, why this location, the dimensions of the house, exterior desires, and estimated costs for the land, building of the home, and long-term mortgage length of payments,” Hill says.

Here are a few lenders that offer construction-to-permanent loans:

LenderAn Option for
BuildBuyRefiAvailable in every state, offers In-house underwriting, A+ Better Business Bureau rating, 640 minimum credit scores 
TD BankSingle- or double-close options, choose fixed or adjustable rate loans, down payment options flexible
Go Mortgage Corporation0%-5% down payment programs available, lends in 32 states and Washington, D.C.
FMC LendingClose as quickly as 7 days, no minimum credit score needed, prior bankruptcy permitted
Nationwide Home Loans GroupLow down payment programs (up to 100% financing), lends in 48 states, lower rates than its rivals

These are just a few lenders you can consider — so make sure to do your research to determine which one’s the best for you. 

Bottom Line

Is a construction-to-permanent loan right for you? That depends on your needs, goals, and budget. If you don’t want to buy an existing home and prefer to uniquely design and construct a home from the ground up on a lot of your choosing, this may be your best loan option.

“Construction-to-permanent loans are a great way to achieve home ownership in this competitive real estate market where inventory for existing homes is often scarce,” says Buege.

These loans are also worth exploring for existing homeowners looking to move up to their dream home, he adds.