Construction Loan Types: How to Transition from Building to Permanent Financing

How construction loans work

Construction loans are different from traditional mortgages in a few important ways.

1. Draws

A regular mortgage hands you (or actually, the seller) a lump sum of cash at closing, which is secured by the home’s value. A construction loan, on the other hand, disburses funds in stages, called draws, as the construction project hits certain milestones.

Your general contractor typically requests each draw as work is completed, and your lender may even send an inspector out to the property to verify building progress before releasing any of those funds.

2. Interest

During the construction phase (while your property is being built), you'll usually just make interest-only payments on the amount that's been drawn down, not the full loan amount. This keeps your monthly payment manageable while building is in process.

Once construction wraps up, what happens next depends on which type of construction loan you have. And this is where the differences really start to matter.

For instance, with some loans, there's an automatic transition to permanent financing, which is built into the original deal. With others, your construction loan comes due, putting you on the clock to close a brand new mortgage before your construction lender calls the balance.

3. Eligibility

Construction loans tend to have stricter requirements than traditional mortgages, since they aren't secured by existing home equity. And you'll definitely feel that in the eligibility process.

With construction loans, lenders will want borrowers to have good credit and a low debt-to-income ratio (DTI). Other requirements include detailed construction plans and blueprints, a licensed general contractor with a track record, and a realistic budget.

You may also like: How to Get Construction Loan Financing

Different types of loans for new construction

Not all construction loans are built the same (pun intended). The type you pick affects everything from how many times you'll sit at a closing table to whether you're protected if interest rates tick upward while you're still mid-build.

Here's a look at the main construction loan types you'll encounter when financing for new construction.

1. Construction-to-permanent loans (one-close)

A construction-to-permanent loan, also called a one-close loan or a single-close loan, is exactly what the name implies: it’s a single loan that allows you to build your next business property or dream home, funding everything from the construction to the final value.

There’s only one close involved in this construction loan type; that initial close finances the construction phase and then, when the build is complete, your loan automatically converts to a permanent mortgage. You don't have to submit a second application, close a second time or even deal with a second set of closing costs.

One of the biggest benefits of this construction loan type is that you're able to lock in your permanent mortgage rate from the very beginning, before construction even begins. If interest rates go up in the time it takes to build (which could easily be six to eight months or more), you're safe with your locked-in rate.

During construction, you'll usually make interest-only payments, but only on the funds you've drawn. Once building is complete and a certificate of occupancy is issued, this construction loan type converts to a traditional mortgage. That means you'll start making principal and interest repayments on the full loan amount, based on the terms you locked in at your pre-construction closing.

Of course, there is also a downside to this construction loan type: if real estate interest rates actually drop while you're under construction, you're stuck with the rate you originally locked in. You can always refinance into a loan with a better rate, but that usually means another application, closing, and additional costs.

2. Two-close construction loans (stand-alone construction loans)

A stand-alone construction loan is also called a two-close loan. This construction loan type treats funding the construction of your property and your permanent financing as two completely separate transactions.

With this construction loan type, you'll first get a short-term construction loan to fund your build. Once construction is complete, that loan comes due. You'll then apply for a separate (permanent) mortgage to pay off the original loan, with more traditional mortgage loan terms.

As the name implies, there are two closings to this type of construction loan, which means two setsof closing costs and two applications. And while this can absolutely be more of a hassle for borrowers and developers, there are some reasons it might make sense to go this route.

For starters, a two-close construction loan type allows you to shop for the best rates available at different stages of the building process: you can lock in the lowest possible rate for construction and then, if rates have dropped, lock in an even lower rate for your permanent loan. These construction loan types can also be more flexible during the construction process, especially if it's a multi-phase or multi-property project. If you expect your credit score to improve significantly between now and the end of construction, this might be worth considering.

The tradeoff, beyond the extra closing costs, is the interest rate risk. If rates go up between when you take out the construction loan and when you need to close on the permanent mortgage, you're stuck paying the new higher rate... and there's really nothing you can do about it.

3. Owner-builder construction loans

Owner-builder construction loan types are designed for borrowers who plan to act as their own general contractor during the build, rather than hiring someone else. Most lenders won't lend to owner-builders as the risk is much higher without a separate, licensed contractor managing the project. The lenders that do offer this construction loan type typically have stringent requirements regarding the borrower's construction experience and even licensure.

If you're a developer with the experience to qualify for this construction loan type, it could potentially reduce your construction costs. But if you're a homeowner who just wants to save money by DIYing a build, this isn't usually a realistic path.

4. Renovation construction loans

Renovation construction loans are sometimes called renovation loans, or home construction loans for existing properties. These construction loan types are designed for significant remodeling and rehabilitation projects on homes that already exist. Think HGTV: these loans are for your fixer-uppers, major additions, tear-downs and full gut renovations.

These construction loans work similarly to new construction loans in that funds are disbursed in stages, which are tied to renovation milestones. Since the underlying property already exists, lenders already have an asset to secure the debt and therefore have to assume less risk.

Renovation construction loans can roll the purchase price and renovation costs into a single loan, if you're in the process of buying, which simplifies the financing for buyers taking on a project property. They are also a good choice for those who already own a property but want to tackle a big reno or expansion project. FHA 203(k) loans are a common loan option for residential borrowers interested in this construction loan type.

One-close vs. two-close

So, which construction loan type is better, a construction-to-permanent (one-close) or a standalone construction loan (two-close)? The honest answer is that it depends on your situation, your risk tolerance, and even the current interest rate environment when you're ready to borrow.

If interest rates are a big worry for you and you don't want them going up before you're done building, a construction-to-permanent loan protects you. You're able to lock in the rate that will follow you through construction and beyond, before a shovel ever hits the ground. If rates do go up, it doesn't matter.

Combine that with the fact that a one-close construction loan type is simpler (only one application process, only one closing date, and only one set of closing costs), and this is often the best construction loan type for individual home builders or those tackling a single new construction project.

On the flip side, you might be worried that interest rates will fall between now and when construction wraps up, or perhaps you're a developer who needs financing flexibility while juggling multiple properties and projects. In either case, a two-close construction loan type keeps your options open. You can shop around and compare permanent mortgage loan offers as you're ready to lock them each in. Just know that you run the risk of interest rates rising when you go this route, and you'll likely have to pay two sets of closing costs, which will impact your total price tag.

It's smart to run the numbers in both scenarios. Don't just look at the loan rates, but also consider your total cost including closing costs and other fees before you decide.

Can I get both construction and permanent financing?

One of the best things you can do when taking on a new construction project is to work with a lender that can handle both the construction financing and a permanent mortgage. Having both under one roof (another pun intended) simplifies communication and account management. It also reduces the risk of delays between the construction phase and the permanent financing closing, and often makes the overall process smoother — even if you decide to go with a two-close construction loan type in the end.

Biz2Credit works with developers and property owners to access both construction and permanent financing, so you're not scrambling to find a new lender right when construction wraps up and you need a permanent mortgage. Whether you're working on a single-family build, a commercial construction project, or a major renovation, there are financing options worth exploring before you break ground.

Final thoughts

There are many different construction loan types to consider, and the differences between them (especially one- and two-close options) can have real financial consequences. The choice you make at the beginning of a project can either protect you from rate fluctuations or expose you to them, and it can either simplify the transition to permanent financing or add a whole extra layer of closing and fees to the process.

That's why it's so important to know your options before you even start talking to lenders. Understand the benefits of each structure and what you're giving up in return. And if any part of the process feels unclear, be sure to work with a lender that can walk you through both sides of the transaction.