A construction loan is a short‑term, staged loan that funds the building or major renovation of a property, with funds disbursed as work is completed and typically converting to a permanent mortgage when construction finishes.
Unlike a standard mortgage that finances an existing home’s full purchase price based on current value, a construction loan is based on the projected completed value, paid in draws during construction, often interest‑only while building, and is short‑term (usually 6–18 months) before conversion or payoff.
Also called two‑close loans. Lender funds construction only; borrower must secure a separate permanent mortgage at project end. Pros: flexibility if permanent financing markets change; sometimes easier to qualify for short construction term. Cons: requires two closings (extra fees), risk of failing to qualify for permanent financing, and often higher rates during the construction term.
Single‑close loans combine construction financing and the long‑term mortgage into one loan and one underwriting/closing. During construction you typically make interest‑only payments; when finished the loan converts to the permanent mortgage. Pros: one closing, lower cumulative fees, rate lock for permanent financing. Cons: less flexibility to change mortgage terms later, and fewer lenders offer competitive single-close products.
These products finance purchase + renovation or refinance + renovation under government or agency programs. Examples include the FHA 203(k) and Fannie Mae HomeStyle Renovation loan. They have program rules about eligible work, borrower qualifications, and draw procedures—useful for major rehab projects but with specific documentation and limits.
Some lenders offer combined land‑purchase + construction loans; others require buying the land first and then a construction loan secured against it. Combining can simplify financing and reduce costs, but may require larger down payments and stricter underwriting since the land often has no finished collateral value.
Lenders require detailed plans, specs and an itemized cost estimate or hard bid from the contractor. A contractor agreement (fixed‑price preferred), contingency allowances, and a realistic schedule are standard. Lenders use these to structure the loan amount, draws and contingency reserves.
Funds are disbursed in draws tied to construction milestones (e.g., foundation, framing, mechanicals, drywall, finish). Each draw requires inspection and often an invoice or lien waiver before release. Draws limit borrower exposure and ensure funds match completed work.
Lenders typically require third‑party inspections or appraiser verification before each draw, plus contractor invoice and lien waiver documentation to protect against unpaid subcontractor claims. Some lenders retain a small holdback until final completion.
Typical timeline: underwriting & closing (2–8 weeks), construction (6–12 months for a single‑family home depending on scope), final inspection and certificate of occupancy, then conversion to permanent financing or payoff. Timelines vary with project size, weather, permitting and supply issues.
Borrowers usually pay interest only on the outstanding disbursed balance during construction. Because draws increase the outstanding loan, monthly payments may rise as work progresses. Interest is typically charged at a variable or slightly higher fixed rate than standard mortgages.
In construction‑to‑permanent loans, principal and interest payments begin automatically when the loan converts to the permanent phase (after completion). With construction‑only loans, principal typically begins when the borrower secures the separate mortgage to pay off the construction loan.
Conversion triggers include final inspection, certificate of occupancy, and lender confirmation that final conditions are met. Single‑close loans convert without an additional closing; two‑close loans require a separate mortgage application and closing once construction completes.
If a borrower can’t qualify for permanent financing at term end, risks include higher lender penalties, forced refinancing at unfavorable rates, or even foreclosure. That’s why contingency reserves, realistic budgets and prequalification for the permanent mortgage are critical.
Down payments vary by loan type and borrower profile. For custom construction loans, expect 20–25% equity or more; some programs might accept lower down payments (e.g., VA, FHA rehab programs). Lenders also require cash reserves to cover interest during construction and contingencies.
Construction loan rates are generally higher than standard mortgage rates because of higher lender risk and shorter terms. Fees (underwriting, inspection, draw fees) can also be higher. In single‑close loans the permanent rate may be locked at closing, offering predictability.
Expect typical mortgage closing costs plus additional construction fees: set‑up fees, funding fees, inspection fees, and interest reserve accounts (an amount to cover interest during construction). Lenders may capitalize interest into the loan through the interest reserve.
Lenders usually require a contingency (commonly 5–10% of the construction budget) to cover overruns. The borrower is ultimately responsible for overruns beyond contingency. Well‑documented change orders and lender approvals are required to fund extra costs.
Lenders typically expect strong credit (often mid‑600s+; better rates at higher scores), conservative DTI ratios (varies by lender), and sufficient cash reserves to cover interest, contingencies and mortgage payments once converted.
Many lenders maintain approved contractor lists or require contractors to meet minimum experience, licensing and insurance standards. Lenders prefer fixed‑price contracts with builder guarantees and warranty provisions.
Owner‑builders (borrowers acting as contractor) are allowed by some lenders, but underwriting is stricter because completion risk is higher. Lenders may require proof of construction experience, higher down payments, and more frequent inspections.
Overruns and delays are common. Mitigation: realistic budgets with 5–15% contingency, conservative timelines, fixed‑price contracts, and lender‑approved change‑order procedures. Maintain a cash buffer beyond lender contingency.
Unpaid subcontractors can place liens. Protect yourself with contractor vetting, certified payments, required lien waivers at each draw, and lender holdbacks to cover final completion. Title insurance endorsements and pre‑closing lien searches are also important.
If a builder abandons or a lender freezes funding, short‑term solutions include emergency funds to finish work, bringing in a new contractor (with lender approval), or seeking bridge financing. Contract provisions and performance bonds can reduce abandonment risk.
Require builder’s insurance (liability, workers’ comp), builder warranties, and performance bonds when available. Lenders often require property insurance naming the lender as loss payee during construction.
Ideal when you need full funding for a ground‑up custom build and want one loan to manage the project and mortgage, especially with a reputable builder and predictable budget.
Appropriate for large structural additions or full gut rehabs where the scope and cost exceed typical renovation loans or when permanent financing should reflect the finished value.
Investors use construction loans for speculative builds, infill, or portfolio expansion. Because repayment typically depends on sales or refinance, underwriting focuses on projected resale values and pre‑sale commitments.
Smaller projects may be better served by renovation loans (FHA 203(k), HomeStyle), HELOCs, personal loans or cash. Use construction loans for substantial new construction or major structural work that requires stage funding and professional oversight.
Shop lenders experienced in construction loans (local banks, credit unions, national lenders). Get prequalified for both construction and permanent phases if possible. Compare fees, rate locks, draw procedures and builder requirements.
At closing a construction loan establishes the loan account, interest reserve (if any) and initial draw to start work. During construction you submit draw requests, inspections occur, lien waivers are collected and funds are released per the draw schedule.
Upon completion lenders require final inspection, certificate of occupancy, final lien waivers and a completion appraisal. Single‑close loans convert automatically; two‑close loans require separate mortgage underwriting and a second closing to pay off the construction loan.
A draw schedule lists project milestones tied to partial disbursements. Lenders release funds after verifying completion via inspection, invoices and lien waivers.
Commonly 20–25% of the finished value or loan amount; program and borrower strength can change requirements. Owner‑builder or riskier projects often need higher equity.
Typically you pay interest‑only on funds drawn during construction. Full principal and interest begin after conversion to the permanent mortgage.
Yes—many lenders offer combined land + construction financing, but combined loans often require larger down payments and stricter underwriting.
Generally yes—construction loans carry higher rates and additional fees because of higher lender risk and short‑term structure.
Some lenders allow owner‑builders but with stricter underwriting, higher down payments, and often proof of construction experience. Many borrowers find it easier to work with an experienced contractor.
There are renovation programs (FHA 203(k), VA Rehab options) and agency loans for certain scenarios; full government‑backed ground‑up construction loans are less common but some programs exist for specific buyer types or communities.
Typically 6–18 months for residential projects; commercial or large developments can be longer. The term covers construction only, with a conversion to permanent financing or payoff at completion.
Maya buys a lot and wants a 2,200 sq ft custom home. Timeline:
Use renovation loans when financing purchase + rehab or moderate to major rehab where program rules match the scope (e.g., FHA 203(k) for FHA-eligible buyers, or Fannie HomeStyle for conventional borrowers). These can be simpler than a full construction loan for remodels.
Smaller projects may use a HELOC or home‑equity loan; bridge loans can help buy land or move between homes. Cash avoids financing costs but requires liquidity. Evaluate cost, tax implications and risk tolerance.
Check FHA 203(k) or VA rehab program guides for renovation financing rules and program details. For draw schedule examples and lender checklists, consult prospective lenders’ construction loan documents—policies vary widely.
