As its name would imply, a construction loan is a loan that a borrower takes out to finance the construction of a home. Construction loans are meant to be short-term loans that get paid off when the home construction is completed (when the certificate of occupancy is issued).
Because construction loans are not standardized like loans that get sold to Fannie Mae and Freddie Mac, there can be variability in the features of various construction loans. Most construction loans do, however, have many things in common, including:
Borrowers using a construction loan to build a home will typically need another traditional mortgage to pay off the construction loan when it comes due. This process entails two mortgage applications with their associated fees, and two closings. To provide more convenience and to make the process easier, may lenders offer construction-to-permanent loan programs. A construction-to-permanent loan program provides both the construction financing during the building phase, and then converts to a traditional mortgage loan when the certificate of occupancy is issued.
The advantage of a construction-to-permanent loan program is that the borrower has only one application and one closing with their associated costs. Construction-to-permanent financing programs can convert to adjustable rate mortgages (ARMs) or fixed rate mortgages (FRMs), depending on the program being offered by a specific lender. All of the decisions about loan term and type of loan (fixed vs.adjustable) are made when the borrower closes on the loan prior to construction.
Many construction-to-permanent loan programs will be priced out with locks that limit the interest rate on the permanent loan. Some may have a "float-down" option that allows borrowers to take advantage of lower interest rates should interest rates decline.
Because of the complexity of the two options available for financing home construction it can be difficult for a borrower to compare a two loan option versus a construction-to-permanent loan. The borrower needs to be careful to compare points that they pay in each scenario and the resulting interest rate on the permanent loan.
Construction-to-permanent loans have the disadvantage that the borrower has much less flexibility to obtain the best interest rate at the end of construction. They are already locked in to a specific deal. Backing out to obtain another loan will typically result in forfeiting points which may have been credited toward the permanent loan in a construction-to-permanent program.
One final alternative that may be available to the borrower is builder financed construction. In this case, the builder finances the construction and the borrower simply shops for and obtains a traditional mortgage when the home is completed. This may, depending on how the builder passes on costs, result in a higher price for the home than if the borrower had financed the construction themselves.