What is a construction loan and why do they need converted to permanent loans?
A construction loan is a type of interim financing, used to build or substantially renovate a property, rather than purchase a pre-existing home. Since traditional mortgages are only available for complete properties, not vacant land, lots, or total renovation/rehabilitation projects, construction lenders offer an alternative to paying for all of the construction costs up front. These loans are based on the projected future value of the completed property.
The most common type of construction loan is construction-to-permanent and it is comprised of two distinct phases: a construction loan phase, followed by conversion or refinance into a permanent loan. These are also known as single-close construction loans because terms for both loans are set from the beginning and the transition from the construction phase to the permanent phase occurs seamlessly. Stand-alone construction loans are less common, but are used to fund the construction of a property and upon completion are either paid off in full, or separate financing has to be obtained.
Construction loans are not designed for the long term however, and many have features that require the loan to be paid off or refinanced. After the initial construction period, the loan may have a balloon feature where some or all of the principal balance comes due. Additionally, construction loans often carry higher interest rates than traditional mortgages and are generally adjustable rate loans from the beginning. Since neither of these are considered desirable features, it makes financial sense to transition from a construction loan to a traditional mortgage.
The majority of construction lenders do not plan on servicing mortgages for the long-term due to the significant amount of capital that would be tied up in the process. Their business model is built on their ability to revolve funds quickly from one investment to the next, speculating in real estate market growth. On the other hand, traditional lenders tend not to offer construction loans due to the risk, speculative nature, and highly specialized experience required to create and manage these loans successfully. Therefore, partnerships between construction lenders and traditional lenders are mutually beneficial and fairly common, especially for construction-to-permanent financing.
How to convert a construction loan into a permanent loan.
Complete the construction process.
Construction loans typically have initial loan terms of 6 to 24 months, during which funds are drawn at specific intervals or milestones in the building process. The construction process is considered complete once all of the draw periods and loan disbursements are done, and all parties have been paid for materials and labor. It’s important to stay within the predetermined time frame for the loan to avoid costly extensions and it’s equally important to stay on budget to ensure that the property isn’t over-built or over-improved for what the local market can support. At this point, the total loan amount can be determined accurately and the process of converting the temporary construction financing into a long-term loan can begin.
Complete the inspection process.
Once the construction is finished, it’s time to have the property inspected one final time by the required local governing body. This might be the county, city, or other municipality, depending on where the property is located. The property will be inspected by a building inspector to ensure compliance with building codes, safety requirements, and habitability standards. Building inspectors are generally employed by the city or county, and required by the state to be certified by the International Code Council.
An official form, called a Certificate of Occupancy, is issued upon the successful completion of the inspection process. The Certificate of Occupancy (COO) is issued by the local building or zoning authority to the owner of the property, attesting that it has been constructed and maintained according to the provisions of national, state, and local building or zoning ordinances and codes. This form signals to traditional mortgage lenders that the property — the collateral on the loan — is eligible for a mortgage.
The inspection process is ongoing throughout the construction of the home, as different aspects like plumbing and electrical work need to be reviewed before they’re encased in walls and other structures. It’s important to schedule inspections in a timely manner so that work isn’t slowed or stopped to wait for an inspector and also so inspections aren’t pushed back to accommodate missed construction deadlines. It is worth noting that building inspectors are different from home inspectors, who are usually hired by home buyers to evaluate existing homes for damage or needed repairs prior to a traditional purchase.
Shop for a mortgage loan.
Now that the property is complete, inspected, and certified for occupancy, it’s time to seek out loan options from traditional mortgage lenders. If the construction loan is construction-to-permanent, then a loan conversion feature may already be in place. It is worth evaluating loan options from a few different lenders to ensure the most favorable rates and terms are being chosen. For most lenders, the conversion process is considered to be a refinance transaction. It generally is not considered to be a cash-out transaction unless funds over and above the construction costs are being added to the new loan amount.
Get an appraisal.
This is the first time that the value of the property will be determined by comparison to other recent property sales in the area rather than the projected value used during the construction process. It can be tricky if the property is part of a brand new development, or is the first to be completed in an area, as comparable sales may be hard to find. There is also the possibility that the local market doesn’t support what was spent building the home. Having the nicest home in the area could make the property more difficult to appraise accurately. Additionally, if the property is unique (a log home, berm home, or otherwise unusual for the area, for example) finding comparable properties might not be possible. Since traditional lenders rely on appraisals to set the value of the collateral for the loan, this is a key step in securing a permanent, traditional mortgage.
Qualify for a permanent loan.
The underwriting process for the permanent loan includes the evaluation of income, assets, and credit in order to approve the loan. Individual lenders and loan programs can have unique qualifying criteria, but generally they will conform to the guidelines set by Fannie Mae, Freddie Mac for conventional loans or the FHA, VA, and USDA for government-backed loans. This means that specific requirements for debt to income ratios, reserves, and credit scores must be met in order to secure a traditional mortgage.
In most cases, the required equity stake in the property will be 20%-25%, meaning that either part of the construction costs will not be reimbursed through the mortgage process or the property will have to appraise for more than the cost to build. There are certain loan programs from the VA and FHA that will allow for a higher loan-to-value percentage, but these have their own unique qualifying requirements and property restrictions.
Complete the conversion process.
Now that the loan has closed and the Deed and Note are recorded with the County Recorder’s Office, regular mortgage payments will begin, according to the terms and amortization schedule set forth in the loan. Homeowners insurance and property taxes may be wrapped into the loan payments with an escrow account, or handled separately from the mortgage. Homeowners insurance is usually based on the replacement cost estimate for the completed property, though additional coverage for belongings, wind/rain/act of God, and flood insurance are all worth evaluating with an insurance agent.
Initially, property taxes will be based on the unimproved value of the land or lot. A subsequent tax assessment, performed by the local tax assessor, will establish a new value for the improved property, and any exemptions will be evaluated (such as homestead, where applicable).
- What is a construction loan
- Purposes of construction loans, and loan types – including construction-to-permanent and stand-alone construction loans
- Limitations of construction loans and why they must be converted into permanent loans
- Background information – brief explanation of why construction lenders don’t often automatically convert construction loans to conventional and why most traditional lenders don’t have construction loans (risk, speculation, experience)
- The terms of construction loans are often undesirable in the long term as well – higher interest rates, adjustable terms, balloon features.
- Steps you need to take to convert a construction loan into a permanent loan.
- Completion of the construction process
- Finishing all draw periods within the terms and framework of the construction loan – not going over budget or over the time frame of the loan.
- Getting a certificate of occupancy, final inspection by local governing body (county, city, etc).
- Definitions of these terms.
- Who does the inspecting and certifying.
- What does the timeline look like for this process? Varies by municipality, but needs to be scheduled in advance – rescheduling and multiple inspections can lead to delays.
- Shopping for a mortgage – permanent loans are offered by traditional lenders
- Limitations if your property is unique (log home, berm home, unusual for the area, or no comparable properties nearby).
- Is this a purchase or a refinance? It’s a refinance – but it doesn’t have to be treated as a cash-out refinance.
- Getting an appraisal on the property – up to now, the value of the home was theoretical and based on construction costs.
- Now the value of the property will be determined by comparison to other recent property sales in the area.
- This can be tricky if your property is in a new development, or is the first to be completed in an area.
- There’s also the possibility that you’ve over-built for an area, i.e. the market doesn’t support what you spent building the home.
- Permanent loan requirements
- Going through the underwriting process
- Equity stake requirement – you won’t be able to take out a 100% loan to value mortgage on the property (20% to 25% equity requirement is common)
- Closing your permanent loan – recording note and deed
- Transition to fully amortizing payments (principal and interest)
- Homeowner’s insurance
- Property tax assessment – improvements (i.e. the construction of your property) changes the value of the parcel
- Completion of the construction process