Understanding the Construction to Permanent Loan Process
Most people have dreamed of building the perfect home from scratch. The ability to create a home which exactly suits your tastes, lifestyle and needs is very appealing….and overwhelming. Where to begin? That vacant lot you saw last weekend with the incredible view would be the perfect place, but where do you start? If you don’t have unlimited cash to put into the project, you’re going to need a construction loan.
Construction Loan vs Traditional Purchase Loan
A construction loan is a short term loan which allows you to build your home and pay for it during the construction process. Once the project is complete, it will convert into a traditional home mortgage. This type of loan can be used to:
- Build your custom home from ground up
- Complete a partially built home
- Buy and renovate a foreclosed property
- Remodel an existing home
- Buy and remodel a fixer-upper property
How Does a ConstructionPerm Loan Work?
- A construction to Permanent loan consists of:
- Pay off of all existing liens
- Cost of construction
- Interest reserve
- Contingency reserve
Construction loans are structured in two parts: construction period and permanent loan. During the construction period, which can be up to 12 months, the interest-only payments will be calculated based on the amount of the loan which is actually drawn. These payments can be applied to the interest reserve account which relieves the borrower of making payments. Once construction is completed, the loan is converted into a traditional mortgage loan, such as a 30-year fixed. One set of loan documents are signed and rates and terms are determined before the loan is closed.
Once the loan is approved, a payment schedule is set up. Based on the construction’s progress, regular payments will be distributed as a draw. As the project moves along, payments will be made to the general contractor to pay for the work performed, sub-contractors and materials. The schedule is negotiated in advance by buyer, builder and lender.
The schedule will include a fixed number of regular payments. These payments are paid in arrears and not in advance. Lenders will charge a fee for project inspection, title update and disbursement so it’s important to keep the number of draws to a minimum.
Extra fees may be assessed if the construction project takes longer than the agreed upon timeline.
Qualifying for a Construction to Permanent Loan
The application process is more complex than a traditional home loan and involves not just the lender, but the builder and construction project manager or contractor as well. Typically the process will involve:
· Qualified Builder
The lender will want to investigate the builder you choose for the product. They must be a licensed and insured general contractor with a good reputation for building custom homes. While you might want to act as general contractor, most lenders will require the project to be overseen by a licensed contractor in order to provide financing.
· Detailed Specifications
The lender will review geological surveys, floorplans, local ordinances, CC & R’s and line item cost breakdown to ensure that the home will be built to code and pass inspection. Builders often use a “blue book” to detail all aspects of the structure for the lender’s review.
As there is no structure or a finished product to appraise, appraisers prepare what is known as a Future Value Appraiser where they use the architectural plans and specifications, assume the project is completed and determine the value by using similar comparable sales.
· Down Payment
Typically a construction loan will require a larger down payment than traditional home loans. The lender is taking a larger risk with a construction project and normally requires at least 25% down however there are some loan programs which only require 10%.
Since the borrower will only be making payments on his/her existing housing and not the construction loan but will be responsible for the payments on the take out loan, lenders use payments on the take out loan to calculate debt ratio.
Lenders will look at your credit history with more scrutiny than a typical home loan. They understand that if you do not complete the project, just as with the down payment requirement, they do not have a solid asset as collateral.
· Cash Reserves
Theconstruction lender will require the borrower to have cash on-hand as reserves. This is to ensure that the project is not delayed in the event that disbursement takes longer than expected and for other unforeseen circumstances.
If you’ve found the perfect spot for your dream home or that perfect fixer upper, then finding the funds to build is the next step. A construction to permanent loan makes it possible for you to finance the project without significant out-of-pocket expenses and in many cases with very small down payments comparable to low down purchase money loans. Understanding the construction loan, its purpose and process can take the mystery out of financing your building project and allow a smooth experience.