What is a construction loan?
A construction loan is short-term financing used to pay for building or substantially rehabilitating real estate. Lenders provide funds in stages as construction milestones are reached rather than as one lump sum. After the project is finished the loan is typically replaced by a conventional long-term mortgage or converted automatically into one (a construction-to-permanent loan).
Key features (plain language)
– Short term: often about one year.
– Stage payments: money is released according to a draw schedule as work is completed.
– Interest treatment: borrowers usually pay interest only on the amount actually drawn, not on the full approved loan.
– Higher cost and down payment: interest rates and required down payments are typically higher than for standard mortgages because the property isn’t yet complete collateral.
– Repayment path: either refinance into a permanent mortgage or convert to a construction-to-permanent loan (if arranged).
Definitions
– Draw (drawdown): a disbursement of funds from the lender to pay for a portion of the construction work.
– Construction-to-permanent loan: a single loan that functions as construction financing during the build and then becomes a standard mortgage when the project is finished.
– End loan: a separate mortgage used to pay off the construction loan at project completion (also called permanent financing).
How a construction loan works (step-by-step)
1. Project plan and budget: you submit detailed construction plans, an itemized budget (sometimes called a blue book), and a contractor agreement.
2. Loan approval: lender reviews plans, your credit, income, and the builder; they may require a 20–25% down payment.
3. Draw schedule set: lender and borrower agree on stages (foundation, framing, roofing, etc.) and corresponding amounts.
4. Fund disbursement: as each stage is completed and inspected, the lender pays the contractor or builder the agreed draw amount.
5. Interest payments during build: you typically pay interest only on the funds that have been disbursed.
6. Conversion or payoff: once construction is finished, you refinance the balance into a conventional mortgage or the loan converts to the permanent mortgage if a construction-to-permanent product was selected.
Eligibility and underwriting basics
Lenders look at:
– Credit score and debt-to-income ratio (ability to repay).
– Down payment / borrower equity (often minimum 20% and sometimes 25%).
– Project documentation: detailed plans, budget, and a licensed, experienced builder.
– Borrower experience: owner-builders (people acting as their own general contractor) face tougher scrutiny and usually must demonstrate construction experience and carry contingency funds.
Owner-builder vs. contractor-built loans
– Standard construction loan: lender prefers a licensed, professional builder/general contractor; lender often pays that builder directly.
– Owner-builder loan: for borrowers who will manage or do much of the work themselves. These loans are harder to get because lenders need convincing evidence of the borrower’s building competence, plus larger cash reserves for contingencies.
Common uses
– New custom homes outside tract developments.
– Major rehabilitation or restoration projects (sometimes financed under construction loan products).
– Not usually needed when buying a completed home in a subdivision because developers often finance construction.
Checklist: what to prepare before applying
– Detailed construction plans and specifications (blueprints and materials list).
– Itemized budget and construction schedule (draw schedule).
– Signed contract with a licensed builder or clear owner-builder plan and proof of experience.
– Proof of funds for down payment and contingency reserves (20–25% typical).
– Personal financial documentation: tax returns, pay stubs, and a list of debts and assets.
– Property appraisal or lot valuation (if buying land as part of the project).
Worked numeric example (simplified)
Assumptions:
– Total project cost: $500,000 (loan amount).
– Annual construction loan interest rate (example): 8% (assumed).
– First draw: $50,000 in month 1.
– Interest payments are interest-only on drawn funds.
Monthly interest for first draw = drawn amount × (annual rate / 12)
= $50,000 × (0.08 / 12)
= $50,000 × 0.0066667
= $333.33 per month
If you draw additional amounts later, you pay interest only on the cumulative drawn balance. For example, if
For example, if you draw an additional $100,000 in month 3, your cumulative drawn balance becomes $150,000 and your monthly interest from month 3 onward is calculated on that $150,000 (not the original $50,000). Using the same 8% annual rate (0.08/12 = 0.0066667 monthly):
– Month 1 draw: $50,000 → monthly interest = $50,000 × 0.0066667 = $333.33
– Month 2 (no new draw): cumulative $50,000 → monthly interest = $333.33
– Month 3 draw $100,000 → cumulative $150,000 → monthly interest = $1,000.00
– Assume month 4 you draw another $200,000 → cumulative $350,000 → monthly interest = $2,333.33
– Month 5 you draw the final $150,000 → cumulative $500,000 → monthly interest = $3,333.33
– Month 6 (no new draw): cumulative $500,
000 → monthly interest = $3,333.33.
Total interest during the six-month draw period (sum of months 1–6 in this example) = $333.33 + $333.33 + $1,000.00 + $2,333.33 + $3,333.33 + $3,333.33 ≈ $10,666.65. If you paid interest each month, that is the