Financing a custom build with a single-close construction loan

For most people, financing a custom home build means qualifying for and juggling three separate loans: one for land, one for construction costs and one for the home's standalone value. However, a single-close construction loan allows you to bundle your land, construction, and permanent loans into one process.

It saves you the trouble of qualifying for and managing three mortgage loans simultaneously. However, convenience comes at a cost. You may still encounter higher interest rates and stricter debt-to-income requirements. 

Let Homes.com guide you through the steps of this loan and explain how to obtain it.

It is a loan that combines lot, construction and permanent financing into one streamlined loan to help you finance building a new home. It's also known as a construction-to-permanent loan, also referred to as a C2P or one-time-close construction loan. You can use one for a custom home project, a modular home, a manufactured home or other forms of off-site construction. These loans challenge the traditional construction loan process by giving borrowers a simpler alternative.

“Much of the market is dominated by local banks that do an interim construction loan before asking the client to get their own permanent mortgage loan somewhere else,” Brian Hurd, senior vice president at Cardinal Financial Company, said in an interview. “With the single-close construction loan, the buyer qualifies upfront for both loans and closes on them simultaneously.”

Once construction is complete, you will sign a modification agreement with your lender to convert it into a permanent 15-or 30-year mortgage loan — either conventional, Federal Housing Administration, U.S. Department of Veterans Affairs or U.S. Department of Agriculture. Most lenders will offer a single interest rate for the entire loan.

You will qualify for a one-time close construction loan using the same process as a Federal Housing Administration, U.S. Department of Veterans Affairs or another government-backed loan type. However, please note that C2P loans often come with stricter debt-to-income ratio requirements.

“To qualify you, we must reverse engineer it, so to speak. We qualify you based on the permanent loan — 30-year fixed, 15-year fixed — and whatever that criterion is,” Hurd said. "At Cardinal, we do Fannie Mae, Freddie Mac, FHA and VA. So, we're qualifying you based on [criteria for the loan types] and then pairing it up with the interim construction loan.”

The process is much easier than people think, Hurd added. It’s no different than approaching a builder and qualifying with their in-house lender.

“The good thing is that we follow agency guidelines for Fannie, Freddie, FHA and VA,” Hurd said. “Again, if you were going to purchase an existing home or a new construction home, the same rules apply. You must meet any local or national building codes.”

Still, there are a few unique factors that you must think about when applying:

• First, you must sign a contract with a licensed builder or contractor. Some lenders will help you vet the builder or contractor to evaluate their experience with custom home projects and their ability to manage the project.  
  
• You will need to buy the lot at the time of your construction loan closing or you have already owned it for six months or less.   
  
• You should have a minimum credit score of 580 if your loan is backed by the FHA. A score of 620 is recommended for VA and USDA-backed loans. Credit requirements for conventional options may vary depending on the lender.  
  
• The home must be owner-occupied once built. And if you build a multi-unit property, you must live in one of the units.   

When you apply, bring your builder contract, design specifications and plans, alongside a detailed budget that outlines every expenditure. The last thing you'll need to submit is a land and proposed construction appraisal report. Your lender will also pre-schedule inspections throughout the project to track progress before closing.

As your next step, the builder will establish a draw schedule to evenly disburse loan funds throughout each phase of construction. Here's an example of a construction draw schedule with percentage values for construction costs:

• Pre-construction land draw: Covers the cost of the lot if you haven't already purchased one 
  
• First phase (20% of your loan): Typically includes lot clearing, drainage and foundational work 
  
• Second phase (20%): Your builder will add framing for the walls and roof before adding the windows 
  
• Third phase (20%): Added elements usually include exterior doors, exterior paint, and rough-in work for plumbing, electrical and the air conditioning system  
  
• Fourth phase (15%): Will include trim carpentry, interior and exterior painting, plumbing, electric and floor coverings 
  
• Sixth phase (20%): Occupancy permit and final inspection before your loan is converted to permanent 

The lender releases each draw amount after an inspection confirms that construction is complete for the corresponding phase. Remember, these funds are already covered by your loan, so you won't have to pay these disbursements out of pocket. However, you will need to make interest payments after the loan is officially closed.

Pro tip: If the construction cost exceeds the loan amount, you will need to cover the gap by depositing the additional funds into your escrow account.

Mortgage rates are often higher, and debt-to-income (DTI) ratio requirements are much stricter for a single-close construction loan. This is true because the lender takes a greater risk.

Stricter DTI requirements act as a buffer for the lender in case your financial situation changes.

“Your house may not be done for six, nine or 12 months,” Hurd said “So, we're assuming that your financial situation is not going to change. That's a risk. People do things they shouldn't do, or sometimes bad things happen to good people. You could lose your job, or whatever the case.”

Aside from that, here are a few more things you should look out for:

• Unexpected expenses: Designing and building your own custom home doesn't always go as planned. You could experience delays related to weather, labor shortages or last-minute design changes. Those delays can have a negative impact on your budget if you aren't careful. To avoid this, double-check with your builder and make sure the budget accounts for unexpected expenses before your lender pre-approves you. 

• New construction appraisal discrepancies: Before getting approved for your one-time construction loan, a new construction appraisal is required. It pre-determines your new home's future value based on blueprints and the value of similar homes. If your appraisal comes back with a lower-than-expected value after you've been pre-approved for a higher amount, you may end up owing more. If that happens, you can negotiate with the builder to lower construction costs or pay the difference out of pocket. 

Here's a step-by-step breakdown of how the one-time construction loan process should go after you qualify:

• Pre-approval 
  
• Select a builder 
  
• Get a new construction appraisal 
  
• Submit documents 
  
• Get a land and proposed construction appraisal 
  
• Obtain the proper permits and approvals 
  
• Apply for the loan 
  
• Pre-schedule inspections with the lender 
  
• Set up a construction draw schedule 
  
• Close on the loan 
  
• Make interest-only payments during construction 
  
• Complete the project and convert your loan into a permanent mortgage