A construction loan funds the building of a home in stages, releasing money as work progresses rather than handing over a lump sum at closing. During the building phase, you pay interest only on the amount that has been drawn so far. Once construction is complete, the loan either converts into a standard mortgage or gets paid off with a separate one. The process involves more paperwork, higher qualifying standards, and closer lender oversight than a traditional home purchase, but the basic mechanics are straightforward once you see how the pieces fit together.
How Funds Are Released: The Draw Schedule
Instead of receiving the full loan amount on day one, your lender parcels out money through a series of “draws,” each tied to a specific phase of construction. A typical draw schedule might include five to seven stages: site preparation, foundation, framing, mechanical systems (plumbing, electrical, HVAC), insulation and drywall, interior finishes, and final completion. Custom residential builds usually follow a 30-day draw cycle, meaning the builder submits a request for the next round of funding roughly once a month.
Before your lender releases any money, a qualified inspector visits the job site to verify the work described in the draw request has actually been completed. The inspector photographs progress, accounts for stored materials, reviews any change orders, and checks how each line item compares to the original budget. The result is a detailed report with percentage-of-completion figures and a payment recommendation the lender can act on.
If the inspection reveals problems, like work that wasn’t done or materials that haven’t arrived, the lender pauses or partially approves the draw. You and your builder are asked to resolve the issue before additional funds flow. This inspect-then-pay structure protects both you and the lender from paying for work that hasn’t happened, but it also means your builder needs to stay on schedule and keep clean records to avoid cash flow gaps.
Interest-Only Payments During Construction
While the house is being built, you make interest-only payments on whatever portion of the loan has been disbursed. If your total loan is $400,000 and $120,000 has been drawn so far, you pay interest on $120,000 that month. As each new draw goes out, your monthly payment gradually rises. This keeps early payments relatively low, which matters because many borrowers are also paying rent or an existing mortgage during the building period.
Construction loan interest rates are typically higher than standard mortgage rates, often by half a percentage point to a full point or more. Because the lender is taking on extra risk (there’s no finished house to serve as collateral until the project is done), the premium reflects that uncertainty. The interest-only phase usually lasts 12 to 18 months, depending on the scope of the project and the terms of your loan agreement.
Single-Close vs. Two-Close Loans
There are two main structures, and the one you choose affects how many times you sit at a closing table and how much you pay in fees.
A construction-to-permanent loan (also called a single-close loan) covers the building phase and automatically converts into a long-term mortgage once construction is finished. You close once, pay one set of closing costs, and the transition from construction financing to your permanent mortgage happens through a loan modification rather than a brand-new application. This is the simpler path for most owner-builders because you lock in your permanent financing terms upfront and avoid the risk of rate changes or qualification issues down the road.
A construction-only loan covers just the building period. When the house is done, you need to apply for and close on a separate mortgage to pay off the construction loan. That means two rounds of closing costs, two sets of appraisals and fees, and two underwriting processes. Some borrowers choose this route because it lets them shop for the best permanent mortgage rate closer to completion, but the added cost and effort make it less common for residential projects.
Qualifying Requirements
Construction loans have stricter qualifying standards than conventional mortgages. Most lenders require a down payment of 20% to 30% of the total project cost, though some will go as low as 10% for loans under certain thresholds. VA-eligible borrowers may qualify with no down payment at all through specialized VA construction lenders.
Credit score minimums tend to run higher as well. Where a conventional mortgage might accept a score in the low 600s, many construction lenders set their floor at 680 to 700. A stronger credit profile also helps you negotiate a better interest rate, which compounds in your favor over both the construction period and the life of your permanent mortgage.
Beyond your personal finances, the lender evaluates the project itself. You’ll need to provide architectural plans, construction specifications, a detailed budget broken down by line item, and a realistic timeline. The lender will also order an appraisal based on the plans, estimating what the finished home will be worth. Your loan amount is typically capped at a percentage of that projected value.
Your Builder Has to Qualify Too
One thing that surprises many borrowers is that the lender vets the builder almost as thoroughly as it vets you. Before approving the loan, most lenders require the contractor to submit financial statements, credit references, and proof of construction experience. They also need to see evidence of proper insurance coverage: builder’s risk insurance, workers’ compensation, and general liability at a minimum.
The lender typically requires a copy of the building permit, the signed construction contract, and lien waivers from subcontractors before each disbursement. Lien waivers confirm that the sub who poured your foundation or ran your electrical has been paid and won’t file a claim against your property. Some lenders also require performance bonds on larger projects, which guarantee the work will be completed even if the builder runs into financial trouble.
If you want to act as your own general contractor, expect additional scrutiny. Many lenders won’t approve owner-builder arrangements at all, and those that do often require significant construction experience and a larger down payment.
What Happens When Building Is Done
Once your builder finishes the home and it passes its final inspections, the lender orders a final appraisal to confirm the property’s value matches what was projected. If you have a construction-to-permanent loan, the loan converts into your permanent mortgage at this point. The terms you agreed to at closing (fixed or adjustable rate, loan length, monthly payment) take effect, and you begin making regular principal-and-interest payments just like any other homeowner.
If you have a construction-only loan, you now need to close on your permanent mortgage. Your new lender will underwrite the loan based on the finished home’s appraised value and your current financial picture. Any change in your income, debt, or credit score since the construction loan closed could affect your rate or eligibility, which is one reason many borrowers prefer the single-close option.
Costs Beyond Interest
Construction loans carry several fees you won’t see with a standard mortgage. Expect to pay for the initial plan-based appraisal, each draw inspection during building, and the final completion appraisal. Some lenders charge a construction administration fee or a higher origination fee to account for the extra oversight involved. Title insurance, survey costs, and permit fees add to the upfront total.
Budget overruns are another cost to plan for. Change orders, material price increases, and weather delays can push the project beyond the original estimate. Most lenders build a contingency reserve into the loan, typically 5% to 10% of the construction budget, to absorb surprises. If your project exceeds even the contingency, you may need to cover the difference out of pocket or negotiate a loan modification, neither of which is fun mid-build. Keeping a realistic budget and a clear line of communication with your builder is the best way to avoid that scenario.