What are Construction Loans?
There are two basic types of loans as it relates to new construction - a construction loan and a permanent loan. But there is now a third choice called a construction-to-perm loan or a “one time close” loan. Let’s first look at how a typical construction loan works and how a permanent mortgage replaces the construction loan.
A construction loan is a loan used to finance the construction of a new property. Simple, enough, right? But a typical construction loan is paid out in installments, or draws, to the builder and owner. Let’s say a couple decides they want to build their very own home. They hire an architect, draw up plans and specifications and soon thereafter contacts a builder to get a quote on how much it would cost to build brand new. These costs include not just the hard costs such as hammers and nails but also soft costs such as property permits and inspections.
These plans and specs are then taken to a bank who will review the documentation and hire an appraiser. The appraiser will then take the building plans and execute a property appraisal based on an “as completed” basis. Even though construction has yet to start, an appraised value can be reached. The bank then reviews the appraisal and costs and sets out a draw schedule.
The builder doesn’t get the entire sum upfront but gets funds from the bank as various stages of construction have been completed. The first draw might be to acquire the land and a plat map while the next draw could be for site clearing and foundation pour. As different stages are completed, more draws are issued. Once the property has been completed the bank then sends out an inspector to verify the home is indeed built and ready for occupancy.
Yet at the end of construction the construction loan must be replaced. This is accomplished by replacing the construction loan with a permanent mortgage. The permanent mortgage be an FHA, VA or USDA or a conforming loan can also be used. If you qualify for an FHA, VA or USDA loan, the down payment and equity requirements will be much less compared to a conventional loan. The permanent mortgage should be in a “preapproved” stage and ready to fund at completion of the construction.
Yet since there are two loans in this scenario, there are two separate loans- the construction loan and the permanent mortgage. These means two separate sets of closing costs and it means applying for two different loans and documenting each separately.
But with a one-time-close loan, both the construction and permanent mortgages are combined into one transaction. There really are no major differences between the process of using two loans or a construction-to-perm, it’s just that both loans are closed at the same settlement at the same time.
What are the Construction Loan Requirements?
One-time-close loans have similar requirements as an individual loan. With the construction loan, the builder must be approved in advance by the lender. It’s best to contact the lender with a list of preapproved builders and pick one from that list but if you’d like to use your own builder, know in advance the builder must be approved before any work can be started. You’ll be provided with a list of approval requirements in advance for your builder to review and complete the application and approval process.
What are the Construction-to-Perm Benefits?
The obvious benefit is only having to attend and pay for one closing, not two. But there are other benefits with a one-time-close loan. For one, you know in advance what the terms of your permanent mortgage are. You can fix your rate upon application knowing that rate will be there when the home is ready for occupancy. You don’t have to make any payments during construction. You certainly can if you want but interest accrues during the construction process and will be added to your final loan amount. Further, because you’ve already been approved for permanent financing, you won’t need to qualify all over again once construction has been completed.
When using the FHA, VA or USDA one-time-close loan, they follow the same guidelines as a standalone mortgage. For example, when using an FHA loan to purchase an owner-occupied property, the minimum down payment is 3.5%. This also applies to the one-time-close loan meaning the final loan amount can be as high as 96.5% of the appraised value. Most standalone construction loans ask for a down payment as high as 20% or even more.
What are the Construction-to-Perm Loan Limits?
One-time-close loan limits must follow the same limits that a standalone mortgage has. For new construction and using a conventional loan, the limits follow conforming limits which is $483,150 in most parts of the country.
With an FHA one-time-close, loan limits are the same as the standard FHA loans used to buy an existing property. So too are VA and USDA limits set for a one-time-close transaction.
What are the Construction-to-Perm Guidelines?
One-time-close guidelines follow similar guidelines for most any other type of mortgage. Borrowers can qualify with a credit score of as low as 620. Income and employment will be verified using the guidelines stated above, a two year history of employment and recent pay check stubs, W2s or federal income tax returns for the past two years in the case of a self-employed borrower. Loan choices can be either a 15 or 30 year fixed as adjustable rate mortgages are not eligible.
If you’re thinking of building and buying a brand new home, don’t think that you have to get two separate loans. Instead, we suggest you compare the traditional two-step process with a construction loan and a one-time-close loan. We can run the numbers for you and let you decide. Knowing what your rate and terms will be in advance, attending and paying for only one settlement and not needing to pay interest charges while the property is under construction are all major benefits that can point you to the one-time-close option.