Everything that you wanted to know about construction to permanent financing explained in a way that is easily understood!
Construction Permanent Lending 101
The Homeowners Guide to Understanding Construction Permanent Loans
Construction permanent loans have been around for quite a long time…and for many good reasons. For those planning to build a new primary or second home, construction permanent mortgages offer convenience, cost savings, and permanent financing options not available with other residential financing products. As its name implies, the construction permanent mortgage is nothing more than two loans rolled into one. The construction portion of the construction permanent loan (known as the “Construction Phase”) is structured to fund the construction of the home. The second portion of the loan (known as the “Permanent Phase”) is structured to offer a permanent long term financing option for the homeowner.
Two Loans With One Closing
Because construction loans and permanent mortgage loans have independent purposes and benefits, each loan is a separate transaction structured to meet specific funding needs. The construction loan is a short-term loan (generally 12 months or less) designed and managed to efficiently fund the actual costs associated with the purchase of your lot (if not already owned) and the construction of your new home. The permanent mortgage, however, is structured to offer long term financing terms (generally 30 years or less) to match your long-term re-payment goals. The biggest advantage to construction permanent loans is, with only one closing, the homeowner is offered loan terms for the two financing phases necessary to go from a vacant lot to a completed residence.
Construction Permanent Advantages
The construction permanent mortgage offers two major advantages over traditional construction financing. These advantages are cost savings and convenience.
Cost Savings-Only one loan closing for two transactions means paying loan closing fees one time. Closing attorney’s charge for their time to prepare closing packages, search property title, and review closing papers with borrowers. Title companies charge for title insurance issuance and other professionals such as appraisers, surveyors, inspectors, flood mapping companies and credit reporting agencies all charge fees for their services. In short, real estate closings can be both time consuming and expensive so the fewer trips to the attorney’s office the better. With a construction permanent loan, these services only have to be contracted once and these fees only have to be paid once.One closing is cheaper than two.
Convenience-Time is money… so why not spend it wisely? Construction permanent loans offer the homeowner an opportunity to determine financing options and loan terms for two transactions at the same time. Making informed construction financing decisions up-front means one application, one approval process, and the advantage of locking a permanent mortgage rate before your home is completed.
The Construction Phase
The construction phase of the construction permanent mortgage is designed to fund the construction expenses associated with the building of your new home. During this period of time (normally 12 months or less) the bank will disburse money to your builder for completed work on your home. In most cases, money will be disbursed once per month and the amount of money disbursed is based upon the percentage of work completed since the last disbursement. These monthly disbursements are called “Monthly Draws” and are administered to assure that project funding matches the project progress. For example, if the your house is 30% complete your loan will be funded to 30% of those approved proceeds set aside for actual construction financing. Funding construction permanent loans in this manner assures all parties concerned that your loan is neither over nor under funded. As your builder makes construction progress, and your home nears completion, your loan balance will increase. You will receive a monthly statement from your lender and that statement will reflect your loan balance including any draws processed since the last statement. During the construction phase you are only required to make interest payments based on the outstanding balance of your loan. Naturally, as your loan balance grows to match the construction progress of your home, your monthly amount owed for interest will increase. Only when your home is 100% complete will your loan balance be fully funded. Once your construction loan has been fully advanced and your new home is fully complete, your loan will be modified into a permanent mortgage.
The Permanent Phase
The permanent phase of the construction permanent loan is the phase whereby the homeowner is offered loan terms to both pay off the balance on their construction loan and terms for the repayment of their home on a long-term basis. This permanent phase is really nothing more than a traditional mortgage loan and offers all the long-term re-payment options that other purchase money transactions afford. As a traditional mortgage, the homeowner can pick from a variety of conventional and Jumbo options including those with both fixed and variable rate features. As both the construction and the permanent phases are closed prior to the start of construction, the homeowner is required to decide on the terms of their permanent mortgage during their loan application process.
Applying for a construction permanent loan is very similar toapplying for a traditional mortgage loan. In addition to the normal asset and income documents required for a traditional purchase mortgage, your lender will need a set of plans, building specifications, and a copy of the contract from your builder. If all of these aren’t finalized prior to your first appointment with your lender, you will still be encouraged to meet with your loan officer to discuss the details of your particular transaction. Your builder may also need to be approved by your lender so be sure to ask about builder approval prior to your first meeting with your loan officer. The builder approval process is critical, as your lender will verify that your chosen builder has the experience, financial, and licensing credentials necessary to successfully complete your project. In addition to plans, building specifications and a contract or cost estimate, your lender will likely need additional income and asset documents from you at, or just after, your application meeting. If given the opportunity, you should ask your loan officer for a complete list of these required documents prior to your first meeting to discuss the construction permanent financing of your new home. Each borrower’s situation is different, but, in general, the following items will be required of most borrowers during their application process and certainly prior to loan commitment:
- Last Two Years of W-2’s and 1099’s Issued
- Last Two Years of Personal and Corporate Tax Returns (If Corporate Returns Apply)
- All K-1’s Associated With Corporate Returns (If Corporate Returns Apply)
- Pay Stubs Covering Last 30 Days
- Checking, Savings, Investment, and Retirement Account Statements For Last 60 Days (All Pages Will Be Required)
At, or shortly after your application, your lender should be able to offer you a construction permanent mortgage closing cost worksheet that provides details on closing fees, cash needed to close, and anticipated payments during construction and after your loan is modified to your permanent mortgage. Reviewing this estimate with your lender and taking the time necessary to understand your transaction is critical to a smooth loan process. The initial meetings with your lender are the best time to ask any and all questions associated with your construction and permanent financing. Many borrowers find that having all borrowers present at the initial meeting with their lender proves invaluable. At this stage of the application process you should plan to ask questions and take notes. Be sure you are comfortable with your down payment requirement, cash to close figures, construction and permanent loan options, and final monthly payments.
At the appropriate time during your application process, an appraisal of your new home will be ordered from a State Licensed Appraiser. This appraisal will be completed based on the location of your building lot and the plans, building specifications and contracted cost to construct your new home. Once completed, you will be provided with a copy of the appraisal on your new home for review. The appraisal on your new home is an important part of the loan review process as it gives you, your lender, and your builder (if you provide a copy) an indication of the market value of your completed lot and residence. Appraisals can indicate a final market value that equals, is less than, or exceeds the total costs of your lot plus improvements including your residence. Appraisals are critical to homeowners and lenders alike as they utilize an industry accepted method for determining final market value of proposed construction. Your lot and the home you are planning to build are compared to at least three other similar properties that have sold recently. Adjustments to the sales prices of the comparable properties are made by the appraiser to arrive at an indicated value of your new home and lot. The final value determined by the appraiser is an indicated value and does not guarantee the homeowner or the lender that the home would sell for that price if offered for sale in the open market. It does, however, provide insight into prices paid for similar properties and utilizes an industry-accepted method for final value determination. Please keep in mind that appraisals are both a science and an art and only offer a value at the time of appraisal. Your home may increase, decrease, or have a similar value at some point in the future.
Your completed appraisal is added to your application and supporting documents and, at the appropriate time, submitted to an underwriter for approval. Once your loan is fully approved by your lender’s underwriter, you will be provided with a loan commitment that you can share with your builder. Most borrowers can obtain a loan commitment within 30 to 45 days from application. Your loan officer will be your primary contact throughout this process and is responsible for all aspects of your transaction including those issues leading up to and after your loan approval is issued. Your loan officer is your advocate, educator and voice before, during, and after your loan is closed. Experienced construction permanent loan officers are adept at offering appropriate financial solutions to take you and your loan application from foundation funding to being handed a set of house keys.
Common Terms Associated With Construction Permanent Financing
Lot Release Fee-The amount of money disbursed at the initial closing of the construction permanent loan to pay off any remaining balance owed on a customer’s lot loan. Lot Release Fees only apply in cases where, at time of application, the borrower still owes money on a previously established lot loan. Lot Release Fees are paid in order to put the construction permanent lender in a first lien position on the subject property.
Construction Interest-The amount of money paid by the borrower during the construction of their home. This is generally an interest only payment and this monthly payment grows as the borrower’s loan balance increases.
Permanent Monthly Payment-This is the traditional monthly payment that the borrower will pay beginning with their first permanent mortgage payment. Also known as PITI, this payment will generally include principal and interest as well as taxes and insurance if the borrower chooses to establish an escrow account. (Escrows are required in cases where loan to value exceeds 80%.)
Modification-This is the paperwork executed by the borrower to convert a construction loan into a permanent mortgage loan. This paperwork is only signed after the borrower’s home is fully completed and their construction loan is fully advanced.
Closing Fees-These are the fees collected at the closing of the construction permanent loan that cover all fees associated with both the construction and permanent phases of a borrower’s financing package. These fees are broken down during the initial application process and itemized on a Closing Cost Worksheet provided to the borrower by the Loan Officer.
Monthly Draws-The amount of money disbursed by the lender to the builder to cover the costs associated with the construction of the new home. Monthly draws are based on a pre-determined percentage schedule and will match the construction percentage progress of the home.
Construction Rate-The interest rate charged to the borrower during the construction period and applied to the sum of the monthly draws.
Permanent Interest Rate-The interest rate charged to the borrower for the permanent financing arrangement. This rate can be fixed or variable as determined by the borrower and lender.
Change Orders-Any work order changes negotiated between the borrower and the builder after both parties execute the final building contract. The borrower normally pays the change order fees directly to the builder as the changes are requested, priced, and agreed upon by the homeowner and builder. Change order funds are generally not included in available construction funds from the lender and most contractors require that change orders be paid for at the time of the request and prior to completion/performance by the builder.
Allowance Items-Those items in a contract between the homeowner and the builder that are identified in the builder’s contract to be associated with a spending budget for the homeowner. For example, the builder’s contract may specify that the homeowner has a certain pre-determined amount of money available to spend for personal preference items. Personal preference items may include, but are not be limited to, lighting fixtures, plumbing fixtures, landscaping, windows, floor coverings and tile applications, exterior and interior trim packages, garage and pedestrian doors, appliances, cabinets and counter tops. The builder’s final price on the contract may include any of these allowance items or none of these allowance items, but it should include an amount of budgeted dollars for each item. The homeowner is encouraged to review any and all allowance items carefully and determine that the builder has allocated sufficient money for each allowance item to meet or exceed the homeowner’s quality/quantity expectations. Personal preference items can vary a great deal in cost. If your builder has a showroom or selection area, please spend the time necessary to make your selections in advance and confirm the total costs of all allowance items prior to contract execution.
Foundation Survey-This is a survey that is often done right after the builder has completed the foundation of your new home. They are important because they indicate the exact location of your new home while in its earliest stage. Any errors in location identified at this early stage are less expensive to correct.
Final Survey-This is a survey that is done at the completion of your home. This survey will not only indicate the location of your foundation but also all other site improvements including decks, drives, porches, fencing and other site improvements.
Construction Phase-The period of time while your home is still under construction. During this phase, the terms and agreements associated with your construction loan will apply.
Inspections-Licensed NC Appraisers are often utilized to perform periodic inspections of your new home while it’s under construction. The inspection report is completed by the appraiser and delivered to the bank for review prior to any construction funds being disbursed to your builder. The inspector will only give the builder credit for completed work. Materials delivered to the site but not yet installed will not be counted towards progress available for funding.
Builder’s Risk Insurance-This is a specific insurance policy issued by commercial and private insurance carriers that protects the homeowner and builder against certain natural and manmade claims during the construction of your home. Builder’s Risk Insurance is often provided by the builder but is sometimes a homeowner responsibility. If you are unsure, please ask your builder to clarify who is responsible for providing and paying for this coverage. Details regarding coverage and other policy details should be directed towards the issuing agent and/or your closing attorney.
Final Draw-This is the last draw posted against your construction loan and is only issued once the home is deemed 100% complete by the inspector.
County Building Inspections-These are building inspections performed by the county Building Inspector to certify that the work performed at various stages of construction meets the minimum county building code. Only projects that meet the minimum county building code will be issued a Certificate of Occupancy.
Certificate of Occupancy-This is often referred to as the CO. Only after the county has passed all the necessary inspections of your home during construction will a final Certificate of Occupancy be issued. Lenders generally require a copy of the CO prior to preparing your file for modification to a permanent mortgage loan.
Private Mortgage Insurance-This is an insurance policy that reduces the potential dollar loss that lenders face when loans go into foreclosure. This insurance is mandatory on all loans that exceed 80% loan to value. The expense of this policy is paid by the borrower and only helps offset lender losses in foreclosure situations. Ask your lender about potential alternatives to avoid paying Private Mortgage Insurance.