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How Construction to Permanent (C2P) Loans Work
A construction to permanent loan, or C2P loan, enables a borrower to finance the cost of building a new home or significant renovations, including for a tear-down or fixer upper, with a single mortgage. A construction to permanent loan is a potentially attractive alternative to a borrower arranging two separate loans to build or renovate a home: one short-term loan to finance property construction and a second, permanent mortgage that replaces the construction loan when the project is completed and the borrower occupies the property.
There are multiple borrower benefits to a C2P loan as compared to a separate construction loan. The borrower obtains one loan instead of two separate loans which reduces closing costs. Additionally, the borrower applies for one mortgage at the beginning of the process without needing to re-apply or re-qualify for the permanent mortgage and there is typically no need for another appraisal when the mortgage converts from a construction loan to a permanent mortgage. A construction to permanent loan also provides the ability to arrange a permanent mortgage well in advance of completing property construction or renovation.
The program provides the opportunity to lock-in the mortgage rate for the permanent mortgage six months to a year in advance of completing property construction or renovations which protects the borrower against an interest rate increase during the construction phase. This also potentially enables the borrower reduce or “float-down” the mortgage rate if rates decrease during the construction phase. Locking or floating-down the rate on the permanent mortgage may require the borrower to pay an additional fee.
The borrower may be able to change mortgage programs when the loan convert from a construction loan to a permanent mortgage. For example the borrower could decide to switch the permanent mortgage from a fixed rate to an adjustable rate mortgage (ARM).
The best types of lenders for C2P loans include:
- Regional banks
- Credit unions
- Banks that you have an existing relationship with including having a checking, savings or investment account with the bank
The table below compares rates and closing fees for lenders in your area. Contact multiple lenders to understand if they offer C2P loan programs. Shopping for your mortgage is also the best way to find the lender and loan program that are right for you.
In addition to conventional construction-to-permanent loan programs, both the FHA and USDA loan programs can also be used to purchase land and build a home. You can use both of these low down payment programs as the permanent mortgage for a C2P loan.
With these mortgage programs, you work with a lender to arrange the short-term construction loan which is used to finance the land acquisition and construction costs. When the building is complete, the construction loan is replaced by a permanent FHA or USDA mortgage.
- Review our FHA Mortgage Guide
The mortgage terms for the permanent FHA or USDA loan are set when the C2P loan closes, so you benefit from a single closing and locking in your permanent interest rate. Both the FHA and USDA programs are insured by the government so you benefit from a lower mortgage rate. Both programs, however, require you to pay upfront and monthly mortgage insurance fees and apply borrower income or loan limits, which may restrict your loan amount.
- Review our USDA Home Loan Guide
The construction phase of a construction to permanent loan is typically six months to a year depending on the timeline to construct or renovate the property. During the construction phase, the mortgage is typically interest only so the borrower pays only interest and no principal while the property is being built or remodeled. Although the interest rate during the construction phase may be higher than the interest rate on the permanent mortgage, the mortgage payments are lower because the borrower only pays interest. Please note that the outstanding principal balance of the mortgage is not reduced during the interest only construction phase.
Instead of receiving the full proceeds from the loan immediately after the mortgage closes, the proceeds from the loan are disbursed to the borrower, or drawn down, over time based on the financing required to complete the construction. This draw down mechanism helps reduce financing costs for the borrower during the construction phase because you only pay interest on the funds you have drawn down as opposed to paying both interest and principal on the total amount of the loan. It is important to highlight that the C2P loan is only drawn down after the borrower’s down payment has been exhausted.
As an example, let’s assume that a borrower makes takes out a $400,000 construction to permanent loan and makes a $100,000 down payment (25% of loan amount). If construction costs for the first month are $130,000 then $100,000 of those costs would come from the borrower’s down payment and the remaining $30,000 would come from drawing down the C2P loan. In this case, for the first month, the borrower only pays interest on the $30,000 initially drawn down as opposed to paying interest on the full $400,000 loan amount.
The draw down schedule is typically agreed to by the lender, borrower and contractor before the loan closes and reflects the construction timetable and financing requirements for the project. Additionally, in most cases lenders require ongoing inspections at each stage of the construction process before releasing additional funds to the borrower. The inspections ensure that work on the construction or renovation project is proceeding according to the plans originally submitted by the borrower and that all contractors are being paid as the project progresses. Lenders may not release additional disbursements if there are liens on a property such as a claim from an unpaid contractor. Please note that inspections are performed to verify the progress of the project and not the quality of the construction or work.
Our personalized mortgage quote form enables you to compare loan proposal from leading lenders near you. Our quote form is free, easy-to-use and requires minimal personal information. Compare multiple loan quotes to find the best mortgage terms.
When property construction or renovations are completed a final inspection is performed to confirm that the project was properly completed according to the architectural or building plans. The inspector issues a certificate of occupancy verifying that the property is suitable to live in. The lender re-confirms that there are no outstanding liens on the property.
At this stage the loan converts into the permanent mortgage based on the terms agreed to by the borrower and lender at the beginning of the mortgage process. Most construction to permanent loans convert into a permanent fixed rate or ARM. The interest rate for the permanent mortgage is set. If the borrower locked the mortgage rate, it should not change even if interest rates increased during the construction phase. The interest rate may decrease if the borrower elected to “float-down” the rate and mortgage rates decreased during the construction phase. Some lenders may require borrowers provide updated loan or property documentation but the borrower should not be required to re-apply for the mortgage.
When applying for a construction to permanent mortgage borrowers should confirm the cost to lock or float-down the mortgage rate
Lenders require that borrowers submit a detailed construction or renovation plan and schedule when they apply for the C2P loan. Borrowers may be required to submit foundation reports, property surveys and architectural plans. In many cases borrowers are required to re-submit reports and surveys upon completion of the project to verify proper construction.
The lender orders a property appraisal to determine the estimated fair market value of the property after the construction or remodeling is completed. The appraiser reviews the architectural plans for the property in addition to other inputs to assess the property’s value. The loan-to-value (LTV) ratio is usually based on the as-completed fair market value of the property but in some cases the lender uses the total cost of construction plus the cost of the land the home is built on.
Most construction to permanent lenders apply a maximum LTV ratio of 75% - 80%, which means you are required to make a down payment of 20% - 25%. The down payment required is based on the construction loan amount and not the as completed property value. You are required to fund the down payment when the loan closes and not when construction is completed. Please note that the net value of the land -- the value of the land minus any loans secured by the property -- on which the home is built can be used to meet all or part of the down payment requirement. For example, if you own a plot of land outright, you can use the full value of the land to meet the down payment requirement for a C2P loan.
Borrowers typically are required to work with a licensed contractor or builder who is approved by the lender. The lender may require the contractor to sign the loan agreement that outlines the key loan terms including the schedule of disbursements. Given how construction to permanent loans work it is crucial that the borrower and contractor are in total coordination on the budget and timeframe for the project. Lenders also typically include a cushion in the mortgage amount to fund unanticipated project expenses. Constructing a house is almost always more expenses than expected and takes longer to complete. Including a cost buffer in the C2P loan helps to make sure that you reach the finish line when you build your home.
When budgeting construction costs, borrowers should build-in a 10% - 15% cushion to account for unexpected costs
Borrowers are also required to meet the lender’s qualification guidelines including credit score, debt-to-income ratio and reserve requirements. You are required to demonstrate that you can afford the C2P mortgage payment. Because you do not occupy the home during construction you have the extra monthly housing costs. You should fully understand the C2P loan requirements before applying to make sure that you qualify for the program.
Use the FREEandCLEAR Lender Directory to find top-rated lenders that offer C2P loans.
Owner-occupied primary residences and vacation properties are eligible for construction to permanent loans. Most lenders do not offer construction to permanent loans for investment properties. Many lenders also require the property financed to be a detached, single-unit residence.
Related FREEandCLEAR Resources
Sources
"Construction-to-Permanent Financing: Single-Closing Transactions." Mortgage Products. Fannie Mae, August 2019. Web.
"Construction Conversion and Renovation Mortgages." Freddie Mac Learning. Freddie Mac, December 2019. Web.
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