Understanding Construction to Perm Loans

Construction to perm loans are a hybrid of two different loan types - a construction line of credit and a conventional “permanent” home mortgage. Construction to perm loans are most appropriate for the construction of a primary residence.  

Construction to Perm Loan Stages

During the building phase, the construction to perm loan is paid out in “draws” as construction progresses. Interest is only charged on the disbursed amount. The borrower can pay the interest or utilize an “interest reserve” which allows the borrower to defer payment until construction end. The accrued interest is capitalized into principal when the loan converts. Borrowers should note that an interest reserve will lower the amount of funds available for actual construction, as well as mandate higher monthly payments on the permanent loan.

At completion, the loan converts into a permanent (“perm”) loan which behaves like a conventional mortgage with level monthly payments.

Terms of Construction to Perm Loans

Lenders typically finance up to 80% of the finished value of the property (80% LTV), but this amount can vary by lender. Often loan costs can be 100% of construction costs and land acquisition.

Borrowers may roll the cost of purchasing the land into the loan amount, or they may have purchased the land previously.  If the land is owned prior to construction, the borrower’s equity in the land can be counted when LTV is considered.

Construction to perm loans carry two different interest rates during respective loan phases. The interest rates are locked at closing, which occurs at the beginning of the construction phase. Usually the construction interest rate is one to two points higher than the perm interest rate.

Advantages of Construction to Perm Loans

The advent of construction to perm loans came from drawbacks to residential construction finance. Construction loans usually have a balloon payment due within a few months of the end of construction. Borrowers would refinance the loan into a conventional mortgage with a longer repayment term. But the existence of a prior loan often dragged the borrower’s credit score down, making it harder to qualify for the second mortgage. The second closing also added thousands of dollars in closing costs to the process.

The second risk involved the home’s LTV. If the finished home’s value did not appraise above the cost of construction - due to overbuilding or a decline in the market - the borrowers could not refinance the line of credit and faced a balloon payment. Lenders required borrowers to have a cash reserve - between 30% to 50% of the final property value - to mitigate this risk. This put building a home out of reach for many borrowers, particularly in areas where housing stock was limited.

Construction to perm loans alleviate these problems by allowing banks to use one appraisal - conducted before construction begins - to determine the projected property value. The single appraisal, with the streamlined application and closing process, both saves money and ensures that the borrower will be able to convert his construction loan into a conventional mortgage. The process also determines whether the proposed home is realistic for the market.