What a construction loan is and how it differs from a regular mortgage
A construction loan is money a bank lends you specifically to pay for building a house or major renovation, not to buy one that already exists. The lender releases the money in stages as construction progresses, rather than handing you a lump sum on day one. You pay interest only on the money that has been drawn so far, not on the full loan amount.
This is different from a standard mortgage, where the bank gives you all the money at closing and you start paying it back when ready. With construction, the bank is taking on more risk because the collateral—the finished house—doesn't exist yet. If the project stalls or costs balloon, the bank's security is uncertain. That's why construction loans have stricter requirements and higher interest rates than mortgages.
Most construction loans are short-term, lasting 12 to 24 months while the house is being built. Once construction is complete, you typically refinance into a standard mortgage to pay off the construction loan. Some lenders offer construction-to-permanent loans, which convert automatically to a mortgage when building finishes, so you don't have to explore twice.
Key Takeaways
- Construction loans release money in stages as work progresses, and you pay interest only on what has been drawn, not the full amount.
- Lenders require detailed plans, a builder's contract, proof of land ownership, and often a down payment of 20 to 25 percent.
- The lender inspects the work at each stage before releasing the next payment, so delays in construction can delay your money.
- Interest rates on construction loans are typically 0.5 to 1 percent higher than mortgage rates because the risk to the lender is greater.
- You will need to refinance into a permanent mortgage once construction is done, which means a second round of underwriting and closing costs.
What lenders require before they will fund a construction loan
Before a lender will commit money, they need to see that you have a solid plan and the financial stability to complete it. You will need to provide a detailed set of construction plans drawn by an architect or designer—rough sketches don't work. The lender wants to know exactly what is being built, how much it should cost, and how long it should take.
You also need a signed contract with a licensed builder that includes a timeline and a detailed budget. The lender will review this contract to make sure the builder is reputable and the costs are realistic for your area. If you are acting as your own general contractor, many lenders will not work with you, or will require additional insurance and inspections.
You must own the land outright or have it under contract. The lender will place a lien on the property, so they need clear title. You will also need to show proof of homeowners insurance and, in some cases, builder's risk insurance, which covers the structure while it is under construction.
Finally, lenders look at your credit score, income, and debt-to-income ratio the same way they do for a mortgage. Most want a credit score of at least 680, though 700 or higher makes approval easier. You will need to show recent tax returns, pay stubs, and bank statements to prove you can handle the monthly interest payments during construction.
How much down payment you will need
Construction loans typically require a down payment of 20 to 25 percent of the total project cost. This is higher than a standard mortgage, which often accepts 10 to 20 percent down. The larger down payment protects the lender if the project runs over budget or the property value doesn't rise as expected.
The down payment is usually due at closing, before any construction money is drawn. Some lenders will let you use the equity in an existing home to cover part of this, but most want to see cash or a liquid asset. If you don't have 20 percent saved, you may need to look for a lender that accepts 15 percent down, though this usually means a higher interest rate or additional fees.
How the draw process works and what triggers each payment
Once your loan closes, you don't receive all the money at once. Instead, the lender releases funds in draws tied to construction milestones. A typical project might have five to ten draws: one at closing (sometimes called the initial draw), then one each time a major phase is complete—foundation, framing, roof, electrical and plumbing rough-in, drywall, and final inspection.
To receive each draw, your builder submits a request to the lender with proof that the previous phase is done. The lender then sends an inspector to the site to verify the work matches the plans and the budget. If everything checks out, the lender releases the funds, usually within a few days. If there are problems—work that doesn't match the plans, unpaid subcontractors, or cost overruns—the lender can hold the draw until they are resolved.
This inspection process protects both you and the lender, but it also means construction delays can delay your money. If your builder is behind schedule or the inspector finds issues, you may not receive the next draw on time. Make sure your builder understands this timeline and builds it into their schedule.
Interest rates and how you pay during construction
Construction loan interest rates are usually 0.5 to 1 percent higher than the rate for a 30-year mortgage at the same time. This reflects the higher risk to the lender. The rate may be fixed or variable depending on the lender and the loan terms.
During construction, you typically pay interest only on the amount that has been drawn. If you have drawn $200,000 of a $500,000 loan and the rate is 7 percent, you pay interest on $200,000, not the full $500,000. As each draw is released, your monthly payment increases slightly. These payments are usually due monthly, though some lenders allow you to defer interest until the loan converts to a mortgage.
When construction is complete and you refinance into a permanent mortgage, your payment structure changes. You will then pay principal and interest over 15, 20, or 30 years, depending on the mortgage terms you choose. The refinance is a separate transaction with its own closing costs, typically 2 to 5 percent of the loan amount.
Why construction loans are riskier and what that means for you
A construction loan is riskier for a lender than a mortgage because the collateral—the finished house—doesn't exist yet. If the builder runs out of money, abandons the project, or does poor work, the lender's security is compromised. If you default during construction, the lender may have to step in and finish the project themselves to protect their investment, which is expensive and time-consuming.
This risk is why lenders are stricter about construction loans. They require more documentation, higher down payments, and more frequent inspections. They also reserve the right to halt draws if they see problems. If your builder misses a important date, goes over budget, or does substandard work, the lender can freeze your funds until the issue is resolved.
To protect yourself, make sure your builder contract includes a completion date, a detailed budget, and a process for handling change orders. If the builder wants to change the scope of work or add costs, get it in writing and submit it to the lender before proceeding. This prevents surprises that could delay your draws.
Construction-to-permanent loans and when they make sense
A construction-to-permanent loan (sometimes called a "one-time close" loan) combines the construction phase and the mortgage into a single loan that converts automatically when building is done. You close once, pay one set of closing costs, and lock in your permanent mortgage rate upfront. When construction finishes, the loan straightforward converts to a standard mortgage without a second closing.
This approach saves you money on closing costs and eliminates the uncertainty of refinancing—you know your final rate before you break ground. However, construction-to-permanent loans are less common than traditional construction loans, and not all lenders offer them. They also typically require a slightly higher down payment and may have stricter builder requirements.
A traditional construction loan followed by a refinance gives you more flexibility. You can shop for the best mortgage rate when construction is done, and you have time to improve your credit or financial situation between the two closings. The trade-off is two sets of closing costs and the risk that mortgage rates could be higher when you refinance.
Frequently Asked Questions
Can I get a construction loan if I don't have a builder yet?
Most lenders will not fund a construction loan without a signed builder contract. Some lenders offer pre-approval for construction loans, which tells you how much you can borrow, but you still need a builder and detailed plans before the final commitment. Start by getting bids from builders and having plans drawn before you approach a lender.
What happens if construction costs go over budget?
If costs exceed the budget in your loan agreement, you have a few options. You can pay the difference out of pocket, ask the lender for a loan increase (which requires re-underwriting), or negotiate with the builder to reduce scope. The lender will not release draws beyond the budgeted amount without approval, so overages can stall the project.
Do I need to have the land paid off before I explore for a construction loan?
You don't need to own the land outright, but you need to own it or have it under contract. If you have a mortgage on the land, the construction lender will place a second lien behind the existing mortgage. Some lenders prefer you to own it free and clear, so check with your lender about their requirements.
Can I use a construction loan to renovate an existing house?
Yes, construction loans can be used for major renovations, though the process is similar to new construction. You need detailed plans, a contractor's bid, and proof of ownership. The lender will inspect the work at each stage. Some lenders call these "renovation loans" or "home improvement loans," so ask about options designed specifically for existing homes.
What if my builder goes out of business during construction?
If your builder fails to complete the work, you will need to hire a new builder to finish. The lender may hold remaining draws until a new contractor is in place and has reviewed the existing work. This is why it is important to hire a builder with a solid reputation and adequate insurance. Some lenders require a performance bond from the builder, which protects you if they abandon the project.