What Is a Construction Loan?
A construction loan is short-to-medium-term financing that funds building a new structure from the ground up. It covers the cost of land (if not already owned), materials, labor, permits, and other building expenses.
Unlike a traditional mortgage where you get a lump sum to buy an existing property, a construction loan releases money in stages called draws. Each draw is released after the lender inspects and verifies that a phase of construction is complete.
You only pay interest on the amount that's been drawn - not the full loan amount. So in month one, when only 15% of funds have been released, you're only paying interest on that 15%.
The core idea: A construction loan is a short-term, draw-based loan that funds ground-up building projects by releasing money in stages as construction progresses. Once the build is complete, the borrower either sells the property or refinances into a permanent mortgage. Terms typically run 12-24 months with interest rates between 7-12%.
Construction loans exist because traditional lenders won't finance a property that doesn't exist yet. There's no collateral to secure the loan on day one - just a set of plans and a piece of land. That's why these loans have higher rates and more oversight than a standard mortgage. See our construction loan programs for current qualification requirements.
How the Draw Process Works
The draw process is what makes construction loans unique. Understanding it is the difference between a smooth project and a cash flow nightmare.
The Draw Schedule
Before the loan closes, the lender creates a draw schedule that breaks your project into phases. A typical schedule might look like this:
| Draw | Phase | % of Loan | Example ($500K Loan) |
|---|---|---|---|
| 1 | Land purchase + site prep | 15% | $75,000 |
| 2 | Foundation | 15% | $75,000 |
| 3 | Framing + roof | 25% | $125,000 |
| 4 | Rough-in (electrical, plumbing, HVAC) | 20% | $100,000 |
| 5 | Interior finishes | 15% | $75,000 |
| 6 | Final completion + certificate of occupancy | 10% | $50,000 |
How Each Draw Is Released
- Complete the phase - Your contractor finishes the work outlined for that draw stage.
- Request the draw - You submit a draw request to the lender, often with photos and documentation.
- Lender inspection - The lender sends a third-party inspector to verify the work is done and matches the approved plans.
- Funds released - Once the inspector signs off, the lender releases the funds. This typically takes 3-7 business days from the request.
Pro Tip: Always have cash reserves to cover expenses between draws. Contractors need to be paid, materials need to be ordered, and the draw inspection process takes time. Budget for at least 2-3 weeks of project expenses in reserve at all times. Running out of cash between draws is the most common reason construction projects stall.
Interest During Construction
During the build, you make interest-only payments on the amount that's been drawn. Your payment grows each month as more funds are released.
Example on a $500,000 loan at 10% interest:
- Month 1 (Draw 1: $75K drawn): ~$625/month in interest
- Month 3 (Draws 1-2: $150K drawn): ~$1,250/month
- Month 6 (Draws 1-4: $375K drawn): ~$3,125/month
- Month 10 (Full $500K drawn): ~$4,167/month
Some lenders offer an interest reserve - they build the expected interest costs into the loan itself so you don't make any payments during construction. The interest accrues and is added to the loan balance. This preserves your cash flow but increases the total amount you owe.
Types of Construction Loans
There are three main types. The right one depends on your project and exit strategy.
1. Construction-Only Loan (Two-Close)
This loan covers only the construction period. Once the build is complete, you must get a separate permanent mortgage to pay off the construction loan.
Pros: You can shop for the best permanent mortgage rate after construction. More flexibility.
Cons: You pay two sets of closing costs. You risk not qualifying for permanent financing later if your financial situation changes or rates rise.
2. Construction-to-Permanent Loan (One-Close)
This combines the construction loan and permanent mortgage into a single loan. You close once, go through the draw process, and then automatically convert to a standard mortgage when the build is done.
Pros: One set of closing costs. Guaranteed permanent financing. Your rate is locked in from the start.
Cons: Less flexibility. If rates drop during construction, you're locked into the original rate (unless you can renegotiate).
3. Spec/Builder Construction Loan
Designed for professional builders and developers who build homes or commercial properties to sell. The borrower is a builder, not the end buyer.
Pros: Tailored to the builder's workflow. Can cover multiple projects under one relationship.
Cons: Requires a track record. The builder must demonstrate experience with similar projects.
| Feature | Construction-Only | Construction-to-Perm | Spec/Builder |
|---|---|---|---|
| Number of closings | 2 | 1 | 1 |
| Closing costs | Paid twice | Paid once | Paid once |
| Rate lock | Construction only | Both phases | Construction only |
| Permanent financing | Separate loan needed | Automatic conversion | Repaid from sale |
| Best for | Rate shoppers | Owner-builders, certainty | Professional builders |
Key Takeaway
For most owner-builders (people building a home they'll live in or keep as a rental), the construction-to-permanent loan is the best choice. One closing, one set of costs, and guaranteed permanent financing. Professional builders and developers typically use spec/builder loans designed for their workflow.
What Construction Loans Cost
Construction loans are more expensive than standard mortgages. The lender is taking more risk - they're lending against a property that doesn't exist yet.
| Cost Component | Typical Range | Notes |
|---|---|---|
| Interest Rate | 7-12% | Interest-only during construction. You pay only on drawn funds. |
| Origination Points | 1-2 points | 1 point = 1% of the loan amount. Paid at closing. |
| Down Payment | 10-20% | Based on total project cost (land + construction). Can be reduced if you own the land. |
| Inspection Fees | $150-$500 per draw | Charged each time the lender inspects completed work. |
| Closing Costs | 2-5% of loan | Title, appraisal, legal, and processing. Construction-to-perm saves you a second closing. |
| Contingency Reserve | 10-15% of budget | Not always required by the lender, but smart to include. Covers unexpected costs. |
How It Compares to Other Real Estate Loans
| Criteria | Construction Loan | Fix & Flip Loan | DSCR Loan | SBA 504 |
|---|---|---|---|---|
| Best For | Ground-up builds | Buy and renovate | Buy and hold rentals | Owner-occupied commercial |
| Interest Rate | 7-12% | 8-14% | 7-9% | 6-8% |
| Term | 12-24 months | 6-18 months | 30 years | 10-25 years |
| Down Payment | 10-20% | 10-15% | 20-25% | 10-20% |
| Funding Speed | 3-6 weeks | 7-14 days | 2-4 weeks | 60-90 days |
| Credit Score | 680+ | 620+ | 660+ | 680+ |
| Disbursement | Draws (staged) | Draws (staged) | Lump sum | Lump sum |
Construction loan vs fix and flip loan: If the property already exists and you're renovating it, a fix and flip loan is usually faster and easier. Construction loans are for when you're building from scratch - either on vacant land or after tearing down an existing structure. The draw process is similar, but construction loans involve more oversight, longer timelines, and more documentation. Read our fix and flip loan guide for a full comparison.
Who Qualifies for a Construction Loan?
Construction loans have stricter requirements than most other financing. The property doesn't exist yet, so the lender is relying heavily on your plan, your team, and your finances.
What Lenders Require
- Credit score: 680+ for most programs. Some go to 620 with compensating factors (large down payment, strong reserves, experienced builder).
- Down payment: 10-20% of total project cost. If you already own the land, the equity in the land can count toward the down payment.
- Detailed construction plans: Architectural drawings, engineering plans, and a detailed scope of work. Lenders need to see exactly what's being built.
- Itemized budget: A line-by-line cost breakdown for every phase of construction. Not a rough estimate - actual bids from contractors.
- Licensed general contractor: Most lenders require a licensed, insured GC with a track record of similar projects. Some allow owner-builders, but terms are less favorable.
- Permits and approvals: Building permits must be in hand or the application must be in process before closing.
- Cash reserves: Enough to cover the down payment, closing costs, and several months of interest payments and project expenses between draws.
Documentation Checklist
- Completed loan application
- 2 years of tax returns (personal and business if applicable)
- Recent pay stubs or proof of income
- Bank statements (2-3 months)
- Construction plans and specifications
- Itemized construction budget with contractor bids
- General contractor license, insurance, and references
- Land purchase agreement or proof of land ownership
- Building permits (or permit application)
- Project timeline
Pro Tip: The most common reason construction loans get delayed or denied is incomplete documentation. Get your construction plans, budget, and contractor information together before you apply. Having a complete package on day one can cut weeks off the approval process.
When Projects Go Over Budget or Over Time
It happens. Materials cost more than expected. Weather delays the foundation pour. The city takes longer on permit inspections. Here's what to expect.
Over Budget
If construction costs exceed your approved budget, you have a few options:
- Use your contingency reserve - This is why smart builders include 10-15% above the estimated budget. If you budgeted $500,000 and set aside a $50,000-$75,000 contingency, minor overruns are covered.
- Pay out of pocket - If the overage exceeds your contingency, you'll need to bring additional cash.
- Request a loan modification - For significant overruns, you can ask the lender to increase the loan amount. This usually requires a new appraisal and updated plans. Not guaranteed.
- Value engineer - Reduce the scope. Swap premium finishes for standard ones. Eliminate non-essential features. This is a last resort but can bring costs back in line.
Over Time
If construction runs past your loan term, you'll typically need a loan extension. Most lenders charge an extension fee of 0.5-1% per month. If your original term was 18 months and you need 3 extra months at a 0.5% extension fee on a $500,000 loan, that's $7,500 in additional costs.
The best way to avoid extension fees: build your timeline with a buffer. If your contractor says 12 months, plan for 15. If you expect permits in 2 weeks, budget for 6.
Key Takeaway
Construction rarely goes exactly as planned. The borrowers who succeed are the ones who plan for the unexpected.
- Include a 10-15% contingency in every budget
- Add 3-6 months to every timeline estimate
- Keep cash reserves beyond what the lender requires
- Choose an experienced GC with a track record on similar projects
Frequently Asked Questions
How do construction loans work?
A construction loan funds ground-up building projects by releasing money in stages called draws. As each phase of construction is completed and inspected, the lender releases the next portion of funding. You pay interest only on the amount drawn. Once construction is complete, you sell the property or refinance into a permanent mortgage.
How much does a construction loan cost?
Interest rates run 7-12%, plus 1-2 origination points and $150-$500 per draw inspection. Since you only pay interest on drawn funds, your monthly payment starts small and grows as more money is released. On a $500,000 loan at 10%, your first month's interest might be $625 (on a $75,000 initial draw), growing to $4,167/month when the full amount is drawn.
What is a construction-to-permanent loan?
A construction-to-permanent loan combines the construction phase and permanent mortgage into one loan. You close once, go through draws during construction, and automatically convert to a standard mortgage when building is complete. This saves a second set of closing costs and guarantees your permanent financing.
How do construction loan draws work?
Your project is divided into phases. As each phase is completed, you request a draw. The lender sends an inspector to verify the work, and once approved, funds are released - typically within 3-7 business days. Most loans have 4-6 draw stages. Always keep cash reserves to cover expenses between draws.
What credit score do you need for a construction loan?
Most programs require 680+, though some go to 620 with a larger down payment and strong compensating factors. Construction loans are considered higher risk because the collateral doesn't exist yet, so credit requirements are stricter than a standard mortgage.
How long does it take to get a construction loan?
Approval typically takes 3-6 weeks from application. This is longer than a fix and flip loan (7-14 days) because lenders need detailed plans, budgets, contractor credentials, and permits. Having complete documentation ready before applying speeds up the process.
What happens if construction goes over budget?
You'll need to cover the difference from your contingency reserve or out of pocket. For significant overruns, you can request a loan modification (not guaranteed). This is why experienced builders include a 10-15% contingency in every budget. Projects that go over budget without reserves often stall mid-construction.
Planning a Ground-Up Build?
We match you to construction loan programs based on your project scope, timeline, and experience.
See Construction Loan Options