When a property owner wants to finance the construction of a new building, they typically have to obtain two loans: one loan for the mortgage on the completed home, and another for the land purchase and construction expenditures.
A construction-to-permanent loan can help owners save time and money — one loan and closing transaction streamlines the financing procedure. However, before starting work on a building financed with a construction-to-permanent loan, both property owners and contractors need to understand the risks.
What is a construction-to-permanent loan?
A construction-to-permanent loan, also called a single-close loan, is a loan used to purchase land and pay for construction costs. When the project is finished, the loan changes into a fixed-rate permanent mortgage loan for 15 to 30 years, depending on the chosen option. Loan funds are used to pay for the lot and construction costs.
This type of loan is suitable for borrowers who wish to construct a bespoke home from the ground up on a selected property with builders of their choosing.
Typically, building on a property from scratch requires two loans: A construction loan is used to purchase the property and begin building on a home, and a second mortgage loan is needed to finance the completed home. A construction-to-permanent loan allows property owners to achieve both objectives with a single loan.
Here are the main benefits and downsides of construction-to-permanent loans and how they can streamline the financing procedure.
What are the upfront costs?
The initial charges for a single-close loan are the same as those for any construction or residential loan. These consist of the following:
- The bare minimum down payment is needed by the lender, which is often 20% of the entire loan
- Additional finance expenses like loan application fees and closing costs might be included by the lender
The borrower must start paying interest-only payments on the money drawn from the loan once it closes, and they can use it to pay for building costs.
Contractor risks with a construction-to-permanent loan
There are common risks that are prevalent in every construction loan program. These risks should be a non-issue when contractors have a comprehensive risk management plan in place.
1. Budgeting problems
The project’s funding may run out if the budget is not adequately managed. Every player in this arrangement faces danger, but the lender is particularly vulnerable. As a result, lenders keep a very close watch on the contractor’s work progress, as well as their invoicing and payment process.
The lender’s responsibility is to ensure:
- The construction loan is always in good standing
- The money that hasn’t been spent is still enough to finish the upgrades
- Draw disbursements are only released for work that has been completed
In order to avoid budget problems, lenders calculate and closely manage the construction loan holdback. They are careful to ensure that every contractor payment is justified by the percentage of work they have performed, as confirmed by the construction progress inspection. Contractors need to pay close attention to detail in their project documentation and draw requests.
This highlights how crucial draw inspections are for keeping balance sheets up to date throughout the project.
Learn more: The construction loan draw process explained
2. Lack of contingency funds
Without a contingency, unforeseen costs like material price increases may cause the project to go over budget, thereby blocking or delaying completion.
Incorporating a contingency reserve, like a construction allowance, into the loan is often used to reduce the impact of rising material costs. The benefit could provide a buffer to reduce the financial stress of rising building expenses. The borrower will need to be eligible for the increase in construction costs, and the home may need to appraise at a higher value.
The answer for contractors, however, is straightforward: Don’t finalize a construction contract unless the construction-to-permanent loan allows for unforeseen expenses.
3. Improper project documentation or budgeting
Preventing time-consuming litigation over the construction contract with the help of these pre-checks can ultimately save you both money and time. A balanced project budget is essential to provide a thorough overview of anticipated spending.
The lender can lower this risk by conducting a thorough project review themselves, or by hiring a qualified vendor to do so before the loan closes.
Unexpected costs raise the risk of default when the project budget is inaccurate. If other crucial paperwork is defective or missing, a project could be considerably delayed before it even begins. This review should, at the very least, examine the appraisal report, the budget, the permits, and the construction contract.
There are deadlines for invoice submissions for a monthly bank withdrawal. If the contractor doesn’t meet the deadline, the invoice might not be sent to the bank and paid until the following month.
Inefficient reporting systems, poor field communication, or a busy finance department are frequently blamed for late billing. To identify areas where systems might be strengthened for prompt invoicing and increased cash flow, think about talking with an outsourced CFO.
Restructuring a few crucial financial processes can help construction companies overcome many cash flow-related financial problems. But if your procedures are perfect and you think the problem is an overworked financial staff, you can think about employing a part-time bookkeeper or financial controller to help balance the burden.
4. Cost-plus agreements raise the chance of default
The borrower pays the contractor for the project’s expenses plus a profit margin in a project governed by a cost-plus contract. These agreements are lawful, but may be detrimental to a lender’s bottom line.
Under a cost-plus agreement, there is little control over spending during construction. Therefore, it is difficult to assume the project’s total cost until it is completed. Although the borrowers and contractors may feel at ease with this arrangement, the lender likely won’t.
Lenders require information about the project’s cost, financial management, and schedule before issuing a construction-to-permanent loan. Because there is no control over expenditure with a cost-plus contract, this level of information is not attainable. Lenders don’t want to put themselves in a position where the funds are depleted before the project is complete.
5. Failing to protect lien rights
Though the rules vary by state, the lender on a construction project generally retains lien priority if the property owner defaults on the loan. However, in the interest of protecting their lien rights, financial institutions will typically require all contractors on the project to submit lien waivers for every payment. These documents prove that required payments were made and prevent mechanics liens from being filed on the property unexpectedly.
Because the lender is typically protected by a higher lien priority, contractors carry enormous financial risk. If the property owner mismanages or misuses the loan funds, the contractor could end up in the hole on the project with limited recourse to collect payment.
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Learn how Levelset can help you easily manage your lien rights on every project to ensure your payments are always protected.
6. Funds transferred without title updates
By requesting a title update at every draw, a lender can further ensure that no mechanics or subordinate liens would supersede the priority of the mortgage or deed of trust.
Title updates must contain:
- Current deed details (i.e., grantor, grantee, recording dates)
- Status of property taxes, if available.
- Information about judgments and liens (i.e., creditor, amounts, and recording dates)
- A photocopy of the most recent deed recorded
Ordering title updates typically requires several manual processes and can take three to five days before the report is obtained. This can drag out the schedule and delay payments, which increases the risk of a mechanics lien claim. As a result, lenders sometimes choose to forego the procedure entirely, which increases their risk.
Recent technological developments have made it possible to change titles digitally, which makes the process considerably faster and more fluid. In many circumstances, this reduces the turnaround time to 24 hours.
7. Lack of insurance coverage
No amount of planning, budgeting, or paperwork will fully protect contractors or lenders from all potential risks. However, several common insurance policies in construction can go a long way to mitigate the risk of loss to all parties.
When a construction-to-permanent loan is used, the lender will often require the property owner or general contractor to purchase a builder’s risk insurance policy. This type of insurance protects against calamities like fire, wind damage, theft, and vandalism while the property is under construction.