What is the difference between a construction loan and a permanent loan?

A construction loan is used during the construction phase and is reimbursed once construction is complete. Then, the borrower will have to pay their regular mortgage, also known as a final loan. A construction loan (also known as a “self-construction loan”) is a short-term loan used to finance the construction of a home or other real estate project. The builder or homebuyer applies for a construction loan to cover project costs before obtaining long-term financing.

Because they are considered relatively risky, construction loans usually have higher interest rates than traditional mortgage loans. A permanent construction loan allows you to finance construction costs and your mortgage together in a single loan. This type of loan is sometimes referred to as a single-closing loan because you only have to go through the closing process once instead of closing a construction loan and a mortgage separately. This loan would allow you to buy the land on which you want to build the house if you don't already own a plot.

The interest payment is calculated based on the loan income that has been paid to your builder to complete the work on the house. Building to permanent loans work by providing you with the funds you need to build the home and mortgage in a single loan package. The editorial content of NextAdvisor is independent of the editorial content of TIME and is created by a different team of writers and editors. Once the construction is finished, the principal amount of the loan becomes a traditional mortgage.

The loan funds are used to pay the costs of the lot and the building and, after construction is finished, the loan becomes a permanent fixed-rate mortgage loan with a term of 15 to 30 years, whichever you choose. Borrowers will want to work closely with an agent to ensure that they understand all the terms of the loan, are getting the best interest rates for construction loans, and are applying for a loan they can afford. That kind of flexibility is useful, especially if the construction takes longer than expected. Borrowers who choose an exclusive construction loan and then seek a separate mortgage must pay two sets of closing costs, one for each loan.

A traditional construction loan is designed to finance the purchase of the land and the construction of the house on that land. So, are there any drawbacks to choosing a construction for a permanent loan? It can be if you pay a higher interest rate on average for the combined loan than you would for two individual loans. During the first few years of the loan, homeowners will pay more for interest than for principal, but as the loan progresses, the situation will change and, at the end of the loan term, the borrower will mostly make principal payments. Instead, you get a single loan to buy the land and build the house, which will become a permanent mortgage when construction is complete.

A permanent construction loan, on the other hand, allows you to save one step and combine both types of loans into a single loan vehicle. Once construction is complete, the balance of the construction loan is converted into a mortgage with a predetermined interest rate and term. A permanent construction loan through Fannie Mae or Freddie Mac can also be used to finance prefabricated homes.

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