A construction loan is a short-term, interest-bearing loan that pays for building or major renovating a property, disbursed in staged draws and usually based on the projected finished value rather than the current value.
Unlike a standard mortgage, which finances an existing, completed home and disburses the full amount at closing, construction loans fund work in progress via a draw schedule, commonly charge higher construction loan rates, require builder requirements and plans up front, and often carry interest-only payments during the build. After completion the loan either converts to a permanent mortgage (construction-to-perm) or is replaced by a separate mortgage (stand-alone construction loan).
Buyers building a custom house from plans typically need construction financing because a traditional mortgage won’t cover a home that doesn’t yet exist. Construction loans let you finance lot purchase, labor, materials, permits and contingency.
Developers and spec builders use larger construction loans (often with staged draws tied to sales or lease milestones) to build single-family homes, multifamily projects, or mixed-use developments.
When an addition or gut renovation is extensive, renovation construction loans or specialty rehab programs (like FHA 203(k) or Fannie/Freddie HomeStyle) are better suited than a small personal loan or HELOC.
Professionals need to understand draw schedules, lien management, construction loan appraisal methods, builder requirements (license, insurance, references), and contingency reserves to reduce risk and keep projects funded on time.
Construction-to-perm loans combine construction financing and the long-term mortgage into one loan and one closing. During construction you typically pay interest-only on disbursed funds; when the home is finished the loan converts automatically to a permanent mortgage at a pre-agreed rate or an adjustable rate, eliminating a second closing and some fees.
Stand-alone loans cover only the construction period. After completion you close a separate permanent mortgage. Pros: flexibility to shop permanent financing, potentially higher loan amounts during construction. Cons: two closings, higher overall costs, and timing risk between construction end and permanent financing.
These programs let buyers or owners roll renovation costs into a purchase or refinance loan. They’re geared to remodels and structural repairs rather than ground-up new builds; qualification, allowable work, and inspection rules vary by program.
Some government and local programs offer construction financing with favorable terms for veterans, affordable housing projects, or infill development. Availability and eligibility vary by state and lender.
Lenders underwrite construction loans based on detailed plans, a contractor or builder contract, an itemized budget, and builder requirements such as licensing, insurance, track record and references. Expect scrutiny of the scope of work, timeline, and cost estimates.
Loan-to-cost (LTC) measures the loan amount against total construction cost (loan ÷ project cost). Loan-to-value (LTV) compares loan amount to the finished value (loan ÷ post-construction value). Construction lenders often emphasize LTC during underwriting and LTV for permanent conversion.
A draw schedule breaks the project into milestones (foundation, framing, rough-in, exterior, finishing) and ties percent-of-total to each. Lenders order inspections or require contractor invoices and lien waivers before releasing each draw.
Most construction loans require interest-only payments on the money that’s been disbursed; the unpaid interest may be paid monthly or capitalized (added to the loan) and then included in the permanent mortgage balance.
With construction-to-perm loans the conversion is automatic at project completion (often with one closing). Stand-alone loans require a separate closing or refinance into a long-term mortgage, exposing borrowers to potential rate changes and duplicate closing costs.
Down payments depend on loan type and borrower profile. Typical ranges: 15–25%+ of total project cost for construction-to-perm; stand-alone loans may require higher equity. Investors and speculative builds often need larger equity or guarantees.
Expect origination fees, appraisal and inspection fees, construction escrows (to hold draw funds), title and recording fees, and third-party review costs (engineers, architects). Single-close loans reduce duplication; two-close loans duplicate some closing costs.
Construction loan rates are generally higher than conventional mortgage rates because lenders face higher performance and completion risk. Rates vary by market and borrower but expect a premium—often 0.5–2.0 percentage points above comparable permanent mortgage rates, plus fees.
Lenders require contingency reserves (commonly 5–10% of build cost) to cover overruns. Lender holdbacks or retainage (5–10% of each draw or final payment) protect against defects and incomplete punch-list items.
Strong credit scores (often 700+ for best terms), consistent income documentation, and conservative DTI ratios improve approval odds. Lenders also look at liquid reserves to cover payments during construction.
Provide architectural plans, a fixed-price builder contract, an itemized budget, builder license and insurance, and timelines. Lenders may require proofs of permits or permit-ready status before closing.
Borrowers may need cash reserves to cover unexpected costs and mortgage payments. Some lenders require seasoning on assets (proof funds held for a certain period) or restrictions on recent large deposits.
Construction loan appraisal often uses a built-to-value approach: the appraiser estimates the expected value when finished and compares that to projected costs to determine acceptable LTV and LTC ratios.
Draw schedules list construction phases and associate a percentage of the total loan amount with each (e.g., 10% foundation, 20% framing, 20% exterior, 25% interiors, 25% final). Timelines and milestones are established pre-closing.
Inspectors verify work completed against the draw request, review contractor invoices and lien waivers, and ensure compliance with plans. Lenders release funds only after verifying satisfactory progress.
Mechanics’ liens let unpaid contractors or suppliers place a claim against the property. Lenders reduce lien risk by requiring signed lien waivers with each draw, direct payments to contractors, and holdbacks or escrow controls.
Best practices: require conditional lien waivers with each draw, pay contractors promptly, maintain a paper trail of invoices and payments, and use joint checks or direct-pay arrangements where appropriate.
Change orders and overruns are common. Negotiate a contingency reserve in the loan and a clear change-order approval process with the builder. Keep a 5–10% reserve and obtain lender pre-approval before approving major extras.
Delays can increase costs and interest expense. Build timeline buffers into contracts, require performance schedules and liquidated damages where appropriate, and consider builder’s insurance or completion guarantees.
Vet builders carefully (references, completed projects, license, insurance). Require retainage and escrow protections, and include clear inspection and remedy clauses in the contract to protect against defects and nonperformance.
For two-close loans the borrower faces interest-rate risk before permanent financing. Strategies: lock the permanent rate in advance (if possible), use rate locks with float-down clauses, or choose a construction-to-perm product to avoid the interim risk.
Appraisers estimate the subject’s value as completed by comparing to comparable finished homes and adjusting for quality, location and planned features. That finished value drives the allowable LTV for conversion.
Title is usually in the borrower's name, but lenders place a mortgage (or deed of trust) on the property. For projects with multiple owners or developer arrangements, title structures can vary.
Lenders require builder’s risk insurance (covers the structure while being built), contractor liability insurance, and later a homeowner policy before conversion. Make sure policies name the lender as an additional insured or loss payee as required.
Buy an existing home with a traditional mortgage. Use a construction loan if you’re building new or the property is not in a habitable, insurable state.
For modest repairs a HELOC or cash-out refinance may suffice. For structural or major renovations, FHA 203(k), HomeStyle, or construction loans are more appropriate because they account for the project’s scope and lien/inspection control.
Choose construction-to-perm to reduce closing costs, avoid interim rate risk, and simplify administration. Choose stand-alone if you need lender flexibility during construction or want to shop permanent rates later.
Get pre-approved to know budget and loan limits. Finalize plans, obtain builder bids, and secure permits or permit-ready documents before closing to prevent delays.
You can close on the lot separately and later take construction financing, or combine lot purchase and construction into one loan. Combining simplifies payments but may increase documentation complexity at closing.
Typical build phases: site work and foundation (1–2 months), framing (1–2 months), rough-in (1–2 months), exterior/roofing (1 month), finishes (1–3 months). Total timelines commonly run 6–12 months for single-family homes.
When construction completes, the lender inspects the finished work, the appraiser finalizes the completion appraisal, borrower signs documents, and the loan converts or the new mortgage closes—sometimes including final escrow funding for retainage and final lien releases.
Look for lenders who offer multiple construction products, have a dedicated construction underwriting team, provide clear draw schedules, conduct timely inspections, and supply references from builders and past borrowers.
Ask about construction loan rates, draw turnaround time, inspection costs, required lien waivers, contingency reserve percentage, retainage/holdback amount, and whether conversion is automatic or requires a second closing.
Watch for vague answers about draw procedures, unusually high fees without explanation, or lenders unwilling to provide sample loan documents. Request a full loan estimate that includes construction-specific fees.
Project assumptions: lot cost $150,000; build cost $400,000; total project cost $550,000. Lender offers a construction-to-perm loan at 6.5% construction rate, converting to a 30‑year fixed at 5.5% on completion. Lender requires 20% equity (down payment) based on total project cost and a 7% contingency reserve.
A construction loan is short-term financing to pay for the construction or major renovation of a property, paid out in stages as work is completed and usually converting to or replaced by a permanent mortgage when the project finishes.
Down payments often start around 15–25% of total project cost, depending on loan type, borrower credit, and whether the loan covers the lot or just construction.
Construction-to-perm is a single-close loan that converts to a permanent mortgage, reducing multiple closings and interest-rate risk. Stand-alone (construction-only) covers just the build and requires a separate mortgage closing afterward.
With each draw the lender or a third-party inspector verifies completed work against the draw request, reviews invoices and lien waivers, and approves disbursement if the work meets the agreed milestone.
Yes—FHA offers the 203(k) for renovations and some construction scenarios; VA construction loans exist but are less common and have specific rules. Availability depends on lender participation and program requirements.
If costs exceed estimates, borrowers need additional equity, lender-approved contingency use, or to renegotiate the loan. Many lenders require a contingency reserve (5–10%) to reduce this risk.
Formula: Project cost = lot + build. Minimum equity ≈ 20% × Project cost. Contingency ≈ 7% × build cost. Closing costs ≈ 2–3% × loan amount.
Example: lot $150,000 + build $400,000 = $550,000 project. Equity 20% = $110,000. Contingency 7% of build = $28,000. Closing costs ~2.5% of loan ($440,000) ≈ $11,000. Estimated cash to close ≈ $149,000.
Request Loan Estimates from 2–3 lenders including construction-specific line items: draw fees, inspection fees, contingency holdback, conversion terms, and construction loan rates. Compare APR, total estimated closing costs, and operational differences (single-close vs two-close).
Construction loans make sense if you’re building new, doing a major renovation that changes value and structure, or developing property that can’t be financed with a standard mortgage. Choose the product (construction-to-perm vs stand-alone) based on your risk tolerance for rate changes and willingness to do a second closing.
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