How Construction to Permanent Loans Work

If you’ve done any research on renovation loans, you’ve probably seen Construction Loans pop up multiple times!

That’s because, for the longest time, these loans were the best way to finance home additions or major home remodels.

Many homeowners still use these loans because of the benefits they provide throughout the process (despite there being other beneficial loans to buy and renovate a property).

There are also a couple of different types of home improvement loans to choose from, so it’s important to have all the information before you decide which is the best option for you.

In this helpful guide, we’ll discuss everything you need to know from what is a Construction to Perm Loan, how construction to permanent loans work, and all the pros and cons of using it to finance your home renovation.

What is a Construction to Permanent Loan?

A construction-to-permanent loan, (also known as a C2P loan or single-close loan), is a type of financing that combines the features of a construction loan and a permanent mortgage into a single package. Construction to permanent loan interest rates are often higher than other home renovation loans.

This loan structure allows individuals to finance both the construction phase of a new home or renovation project and the eventual permanent mortgage to cover the completed property.

In simpler terms, the construction to perm loan offers funding for the construction of a home or project, and once the construction is finished, what makes a construction-to-permanent loan different from other construction loans is that once the home is built, the loan converts into a traditional mortgage, typically with a loan term of 15 to 30 years.

Its structure helps buyers obtain land, materials, permits, and more all within a single financing option.

How Construction to Permanent Loans Really Work

The construction-to-permanent loan model provides a comprehensive financing solution for building or renovating a property. Construction-to-permanent loan work via a two-phase process which ensures a smooth conversion from construction to a permanent mortgage within 1 year.

To understand how construction to perm loans work, let’s delve into a simple example:

Phase 1: Acquisition and Down Payment

When you secure a construction-to-permanent loan, you’ll begin by acquiring the property or land.

For instance, let’s say the property you want to renovate or purchase costs $500,000 and you need another $500,000 for renovations, and you’ve agreed to a 20% down payment.

Then, your project’s total acquisition costs is $1,000,000, and you’d need to provide $200,000 upfront (20% of $1,000,000) to the closing table. This down payment reduces your initial loan balance, which starts at $300,000 (which is $500,000, the value of the home minus the $200,000 your downpayment).

Next, similar to using a Home Equity Line of Credit (HELOC) for renovation, a construction-to-permanent loan only requires immediate interest payments on the borrowed amount - you do not have to make payments on the principal balance.

Hence after closing you’ll begin making interest payments on the $300,000 you borrowed to acquire the property.

Phase 2: Building Financing

Once construction begins, you’ll need approval from the lender based on your submitted plans and cost estimates, and other documents required from your contractor.

This approval triggers the release of funds for construction, allowing you to draw from your remaining borrowing power. You can continue drawing funds until you reach the total borrowing limit, such as $800,000 in this example ($100,000 total project cost less your $200,000 downpayment).

Construction Loan Expert Tip: When considering a construction-to-permanent loan, be prepared for the approval process required for each funding draw. Lenders meticulously review documentation from contractors and builders at each phase of construction before releasing funds. This process can lead to potential delays and disruptions in your project timeline - which is why experts recommend not to use construction loans.

With each draw, your monthly interest payment increases due to the rising principal amount. This reflects the progress of your construction project and the higher funds being utilized.

Upon completing the construction or reaching the borrowing cap (which is $800,000 total in this example), the loan converts into a permanent mortgage. Your monthly repayments will then include both interest and principal components.

What Are The Disadvantages of a Construction to Permanent Loan?

• Stringent Documentation Requirements: Construction-to-permanent loans demand thorough documentation from contractors and builders at each funding phase, leading to complex administrative processes.
• Limited Construction Timeline: These loans typically allow only a 12-month construction period. This limited timeframe can become problematic, especially if there are unexpected delays in obtaining necessary permits and approvals. This is very important to consider because major renovations can take up to 12 months to complete from start to finish (excluding the time it takes to get permits approved).
• Increased Complexity: The dual-phase nature of these loans introduces added complexity compared to traditional loans, requiring borrowers to navigate both construction and permanent mortgage aspects.
• Builder Approval: Lenders often require builders to meet specific criteria, which can limit your choice of contractors and builders for your project. Lenders want to avoid bad contractors as they increase the lender’s risk and your ability to complete the project as planned.
• Continuous Documentation: Throughout the construction phase, you’ll need to provide ongoing documentation, creating a need for consistent communication with your builders and contractors.
• Approval Delays: The detailed checks and balances at each phase can lead to approval delays, potentially impacting the construction timeline and your project’s progress.
• Uncertain Interest Rates: Interest rates for the permanent phase of the loan are not locked in during the construction phase, exposing you to potential fluctuations in rates.
• Higher Closing Costs: The dual-phase nature of these loans can result in higher closing costs compared to traditional mortgages.
• Permit and Approval Challenges: The limited 12-month construction period can be a challenge if your project requires extensive permits and approvals, potentially jeopardizing the completion timeline.
• Risks of Incomplete Projects: If construction encounters unexpected delays or issues, you could be left with an incomplete project while transitioning to the permanent phase of the loan.

Construction Loan Expert Tip: Consider a home equity loan or HELOC versus a construction-to-permanent loan, because of he flexibility and simplicity that home equity options offer.

Home equity loans and HELOCs allow you to tap into existing equity without the stringent checks and balances of construction-to-permanent loans. Additionally, you can use funds for renovations, expansions, or any home improvement project while avoiding the limited construction timelines and potential delays associated with construction-to-perm loans.

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What Are The Advantages of Construction to Permanent Loans?

• Interest Only Payments: They also only require you to pay interest during construction with a payback period once it’s complete, allowing you to better budget throughout the process.
•  Single Closing: A construction to perm loan also only has one set of closing costs, so instead of paying these fees for the loan and your mortgage, they package them into one, which limits what you’ll owe. 
•  Rate Protection: Once your construction loan converts to a permanent mortgage with either a 30-year rate or a 10 to 20-year Home Equity Loan.

Construction to Permanent Loan Requirements & Qualifications

Your lender will require a number of things in order to qualify for construction to perm loan, as well as determine how much you can borrow.

20% Down Payment: You’ll typically be expected to make a down payment of 20% of the loan amount, although some lenders will allow much less, down to 5%.

700+ Credit Score: Construction loans are typically offered by community and regional banks, which will often require a higher minimum credit score to qualify — around 700 or above.

38%-45% or lower Debt-to-Income Ratio (DTI): The lower your debt-to-income (DTI) ratio, the better your chance of getting approved for construction to perm loan. This ratio compares your income and debt payments, and it plays a role in not only construction loans but a lot of other loans as well (in fact, it’s one of the most common reasons why homeowners can’t qualify for a RenoFi loan).

For a construction loan specifically, approvals typically require less than 43% of your income to go towards your proposed house payments, combined with all other debt that you have.

So let’s say your gross income is $10,000 per month (before tax). That means your future house payment + auto loan payments + student debt + credit card bills, and other debt repayments should not exceed $4,300 per month (or 43%). 

High Construction Loan-to-Value (LTV): Just like a normal mortgage, the Loan-to-Value ratio is important to know how a construction-to-permanent loan works.

This value refers to the percentage of your home that you will own and the percentage that is being borrowed. For example, if you buy a home and make a 10% down payment, the Loan-to-Value is 90%.

Qualified Contractor: Lenders want to be confident that the contractor you’ve chosen has a strong reputation and will get the work done on time and on budget. So before they approve your construction loan, you’ll want to ensure your contractor is qualified for your renovation project because they’ll need to approve your choice.

Construction Loan Expert Tip: Before embarking on a construction or renovation project, engage your contractor with well-thought-out questions to ensure clarity and a smoother process. Open communication from the start helps set expectations and builds a foundation for a successful project.

Once a builder is approved by a bank, they don’t have to be approved again, so if your contractor is already on the approved list of the bank you are applying to, they won’t need to go through this approval process.

Your banker will provide their own specific forms, but generally, the builder will need to fill out an application and provide the following:

• Documentation of the builder’s licenses
• Documentation of general liability & workers comp insurance
• References from past clients & material suppliers
• Documentation proving they are current on their payments to subcontractors

Achievable Home Renovation Plans: In order to estimate what your home will be worth AFTER your renovation is complete, your lender will require you to show detailed plans of what the project will entail and how the loan is being used throughout the process. 

An independent appraiser will look over these plans and be responsible for coming up with that estimated future value and will conduct an as-completed home appraisal to do so.

With the help of your builder, you’ll need to provide the following:

• Blueprints/building plans & detailed specifications
• Fully executed contract between you and your builder
• Building permits if applicable
• Contracts for all estimates outside of the construction contract

Can You Write Off Construction Loan Interest on Taxes?

Most of the expenses that pertain to building a new home with a construction loan are not deductible on your taxes. Unlike how using home equity loans for renovation can offer tax deductions on interest payments.

However, once the loan converts to a permanent mortgage, you may be eligible for the home mortgage interest deduction, subject to certain limits and conditions.

Construction Loan Expert Tip: You can potentially deduct the interest you pay on the loan both during and after the construction period as a business expense. Consult a tax professional to understand how this applies to your situation.

Construction to Permanent Loan Alternatives

• Home Equity Loans or Lines of Credit (HELOC): Both home equity loans and HELOCs allow homeowners to borrow against the equity they’ve built in their homes. While home equity loans are given as a lump sum with fixed interest rates, HELOCs are dispersed in draws, similar to construction loans, and have variable interest rates.
  
  Home equity loans have a fixed repayment period with equal monthly payments throughout the life of the loan, and repayment starts almost immediately. With a HELOC, you typically have a draw period of 5-10 years, during which you can access the available credit as needed, making interest payments on only the amount borrowed. After the draw period ends, the repayment period starts with monthly payments on the outstanding balance.

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• Personal Loans: Personal loans are unsecured loans that are instead secured by collateral (aka your home), which is why they typically have higher interest rates. They offer flexibility in terms of accessing your funds and may be easier to qualify for than other loans. Their shorter repayment periods mean a quicker payoff, but typically higher monthly payments as well.

  There are also upfront origination fees for the processing and funding of the loan, which are typically 3-5% of the loan amount.

• FHA 203(k) Loans: FHA 203(k) Loans are one of the few options out there specifically designed for home renovation projects. These loans are insured by the FHA and allow borrowers to finance the purchase or refinance and renovation of a home with a single mortgage. There are two types of FHA rehab loans: the standard 203 (k) loan meant for large-scale and structural work and the limited 203 (k) loan, which only covers non-structural repairs.
  
  FHA Rehab loans have specific requirements for the types of repairs and renovations that can be financed with limits on the maximum loan amount based on the property’s value and location (which tend to be quite low). You’ll be required to pay a down payment of 3.5% based on the value of your home and renovation costs and an Upfront Mortgage Insurance Premium of 1.75% of the loan amount, as well as closing costs similar to any other mortgage loan.

• Cash-out Refinancing: With a cash-out refinance, your existing mortgage is replaced with a new one that has a higher balance, allowing you to take out the difference in cash. If you have a lot of equity in your home, this can help you qualify for a lower interest rate than your current mortgage. This loan option incurs costs similar to those of a mortgage and may require mortgage insurance depending on your loan-to-value ratio (if you have less than 20% equity in your home). 

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Potential Risks and Considerations When Using a Construction to Permanent Loan

The truth is that construction loans were never originally intended to finance home renovations. Instead, they were meant for new construction built on a plot of land. And this type of investment carries a lot of risk for lenders.

Because of this, these loans have very complex and strict requirements to protect the lender, regardless of whether you’re using the loan for new construction or a renovation project. As a one-size-fits-all loan, they often aren’t the best option for homeowners since they don’t consider all the unique circumstances of a project that other loans do. 

This also results in a lot more work involved by all parties than with other home improvement loans, making them a pain for both homeowners and contractors throughout the process.

Three Main Downsides to Using a Construction to Permanent Loan 

1. You’re forced to refinance and pay more. If you’re one of the lucky ones who locked in a great low rate when they were at all-time lows, you’ll be sacrificing that rate for a higher one.
2. You’ll pay higher closing costs. With the refinance requirement of these loans, you’ll also have to pay closing costs on the mortgage + your renovation budget.
3. There’s a complicated draw process. Construction loans require frequent property inspections and lots of paperwork, while only allowing you to make small withdrawals based on project milestones. 

Choosing the Right Financing Option for Your Home Renovation

Choosing the right home renovation loan is a big deal. Not knowing your options or the nuances that come along with each can end up costing you a lot of money unnecessarily long after your renovations are complete.

Before you make any decisions, gather important information like your project scope, timeline, financial information, and your budget, so as you do your research and read through RenoFi’s helpful guides, you can narrow down the options that you’ll qualify for and find the one that best meets your specific needs. 

Compare the benefits, risks, and terms of each financing option before making a decision. And if you need help, RenoFi is here.

Our awesome renovation advisors can help you better understand what is construction to perm loan and how construction-to-permanent loans work, as well as learn more about your home renovation loan options and find the best lenders available to get you started.  Plus, we partner with awesome credit unions who help us offer these lower rates and give you even more flexibility based on your financial situation.

And if you’re looking for a new home improvement loan that not only increases your borrowing power based on the after-renovation value of your property but offers lower interest rates and monthly payments than almost any alternative, ask us about RenoFi Renovation Loans.

Schedule a call or email the RenoFi team today to learn more about how we can help you.