What a construction loan is designed to do
A construction loan is a short-term loan used to pay for building a new home or completing a major renovation. It can cover costs such as land, plans, permits, materials, labor, and some closing costs, depending on the lender and project. Unlike a standard mortgage, which is made on a finished home, a construction loan is underwritten around a building plan and budget.
Because the home does not exist yet, the lender focuses on the project as much as the borrower. It reviews the builder's experience, the construction contract, the plans and specifications, the timeline, and the cost breakdown. Many lenders also require a contingency reserve for unexpected issues. The loan is usually repaid, refinanced, or converted into a permanent mortgage after the home is complete and receives any required occupancy approvals.
Construction loans are not personal loans. A construction loan is typically secured by the property and governed by mortgage lending rules. See what a construction loan is. The CFPB's mortgage tools explain home-secured borrowing.
The draw schedule and inspection process
Draws release money in stages
With most construction loans, the lender does not hand over the full amount at closing. Instead, it uses a draw schedule, which ties disbursements to completed stages of work. This protects the lender because funds are released only after work is verified. It also limits interest on money not yet used.
- Agree on the draw schedule. The loan agreement lists milestones, such as foundation, framing, roofing, mechanical systems, and finishes.
- Complete the stage. The builder finishes the work and gathers invoices, receipts, and lien waivers.
- Request a draw. You or the builder submits a draw request to the lender with supporting documents.
- Inspection occurs. An inspector or lender representative verifies that the completed work matches the draw request.
- Lender approves and funds. If the paperwork and inspection are satisfactory, the lender releases the draw.
- Repeat and close out. The process continues until the final draw. After final inspection and any required certificate of occupancy, the loan is repaid or converted.
A draw schedule is not just paperwork. Delayed draw requests, missing lien waivers, or work that fails inspection can slow the project and increase interest costs. Keep a current budget and communicate before a stage is finished.
One-time close versus two-close loans
One-time close versus two-close loans
Construction financing usually follows one of two structures. In a one-time close, also called a construction-to-permanent loan, the construction loan and the permanent mortgage are combined into a single set of documents and one closing. In a two-close arrangement, you close on the construction loan first and later close on a separate permanent mortgage.
| Feature | One-time close | Two-close |
|---|---|---|
| Closing process | One closing covers construction and permanent financing. | Separate closings for construction and permanent financing. |
| Rate and terms | Permanent terms may be set early or after construction, depending on the lender. | Permanent rate and terms are set at the later closing. |
| Payments during build | Often interest-only or interest reserve payments, then permanent payments after conversion. | Construction-loan payments during build, then new permanent payments. |
| Qualification | You may qualify once for both phases, subject to conditions. | You must requalify for the permanent mortgage after construction. |
| Main risk | Terms may have conditions you must meet before conversion. | Your finances or the market may change before the second closing. |
The better fit depends on how the lender prices each option. A two-close loan can be useful if you expect your financial picture to improve, but it adds a second approval step. A one-time close can reduce the risk of being turned down later, but you still must satisfy the conditions in the agreement. Ask how the rate, fees, and payment change at conversion.
Qualification and underwriting
Qualification and underwriting
Construction loan underwriting looks at the borrower and the project. Lenders review credit, income, assets, debts, debt-to-income ratio, and cash for down payment, closing costs, and reserves. They may also consider the value of the land if you already own it. Because the property is unfinished, the lender relies on the appraised value after completion and the cost to build.
Project documents matter. Expect to provide detailed plans, specifications, a builder's contract, a construction budget, a timeline, permits, and evidence of the builder's license and insurance. The lender may order an appraisal, review the builder's financial strength, and require a title search. If you plan to act as your own builder, some lenders treat the loan as higher risk or refuse it altogether.
Your credit reports and scores are part of the review. You can check reports from the nationwide credit bureaus through AnnualCreditReport.com, the official site under the Fair Credit Reporting Act. For broader guidance, the CFPB explains credit reports and scores. Correcting errors before applying can prevent delays, though it will not guarantee approval.
Costs, interest, and payments during construction
Costs, interest, and payments during construction
Construction loan payments often differ from permanent mortgages. Many are interest-only during the build, and the interest is charged on the outstanding draw balance rather than the full loan amount. As draws are released, the interest payment can rise. Some lenders require an interest reserve to cover payments during construction.
The rate may be fixed or adjustable. If it is adjustable, the rate can change based on an index and margin described in the loan documents. The lender must provide Truth in Lending disclosures that show important loan terms, including the annual percentage rate and finance charge, before you sign. The CFPB's Truth in Lending Act regulations explain these disclosure rules. Review disclosures with the loan agreement, not marketing materials.
Closing costs can include origination charges, appraisal and inspection fees, title insurance, recording fees, and draw fees. Some costs may be financed if the loan-to-value ratio and lender guidelines allow it, but others must be paid in cash. To estimate post-conversion payments, use a loan payment calculator and ask for a sample schedule.
Risks and protections
Risks and protections
Construction loans carry risks that a finished-home mortgage does not. The project may take longer than planned, materials may be delayed, or change orders may increase the cost. If the builder walks away or fails to pay subcontractors, mechanics liens can be filed against the property. If the project stalls, the lender may stop draws, and the borrower may still owe payments on money advanced.
Protections begin with the contract and loan documents. A fixed-price builder contract, a written change-order process, and a realistic contingency budget help control surprises. Lien waivers confirm contractors and suppliers have been paid for their work. Inspections verify progress before money is released. Builder insurance and a clear warranty can also reduce risk, though they do not eliminate it.
Read the default section of the loan agreement carefully. It may describe what happens if construction stops, if inspections are not passed, or if you fail to meet conversion conditions. The CFPB's Ask CFPB resource answers common questions about mortgages and loan servicing. If you have equity in another home, compare construction financing with a HELOC or home equity loan, but those products have different terms and risks.
How to apply and what to compare
How to apply and what to compare
Start by clarifying the project scope, budget, timeline, and builder. Then gather pay stubs, tax returns, bank statements, investment statements, the builder's contract, plans, specifications, and permits. A lender can issue preapproval, but a construction loan is not final until underwriting and inspections are complete.
Compare offers from multiple banks and credit unions. Ask how draws work, who orders inspections, whether there are draw fees, how interest is calculated, whether an interest reserve is required, and what conditions must be met before conversion. Also ask what happens if the project is delayed or costs more than expected. The CFPB's owning a home guide and HUD's homebuying information can help you prepare. Review the loan agreement before signing and keep copies of every disclosure, change order, and draw request.
Construction loans are specialized, so not every lender offers them. Be prepared for a slower process than a standard mortgage and for close coordination among you, the builder, the inspector, and the loan servicer. If the project involves a bridge from an existing home, a bridge loan may be part of the plan, but it is separate with its own terms.