A construction loan is a short-term financing product designed specifically to fund the building of a new home or major renovation. Unlike a traditional mortgage — which you use to purchase an existing property — a construction loan provides funds progressively as work is completed. Understanding how these loans work is essential before you break ground on your custom home.
What Makes Construction Loans Different
The most fundamental difference between a construction loan and a conventional mortgage is how money is disbursed. With a traditional mortgage, you receive the full loan amount at closing and begin making principal and interest payments immediately. With a construction loan, funds are released in stages called draws, tied to specific milestones in the building process.
This draw structure protects both you and the lender. The lender isn't handing over hundreds of thousands of dollars before a single wall is framed. You, in turn, only pay interest on the funds that have actually been disbursed — not the full loan amount from day one.
The Draw Schedule Explained
A draw schedule is a predetermined timeline that outlines when funds will be released and what construction milestones must be completed to trigger each draw. Typical draw stages include:
- Foundation draw: Released after the foundation is poured and inspected
- Framing draw: Released after the structural framing is complete
- Rough-in draw: Released after plumbing, electrical, and HVAC rough-in work is done
- Drywall and insulation draw: Released after interior walls are closed
- Completion draw: Final disbursement after the certificate of occupancy is issued
Before each draw is released, the lender typically sends an inspector to verify that the work has been completed to the required standard. This inspection process adds a layer of accountability that benefits everyone involved.
Interest-Only Payments During Construction
During the construction phase, you typically make interest-only payments on the funds that have been disbursed. This keeps your monthly obligations manageable while your home is being built. Once construction is complete, the loan either converts to a permanent mortgage or must be paid off through refinancing.
For example, if your total construction loan is $500,000 and $200,000 has been drawn to date, you're only paying interest on $200,000 — not the full $500,000. As more draws are released, your interest payments increase accordingly.
Construction-to-Permanent vs. Stand-Alone Loans
There are two primary structures for construction loans. A construction-to-permanent loan (also called a "one-time close" or "single-close" loan) covers both the construction phase and automatically converts to a permanent mortgage when the home is complete. You go through the approval process once, lock in your permanent rate at the start, and avoid a second closing.
A stand-alone construction loan (or "two-time close") covers only the build period. When construction is complete, you must apply for and close on a separate permanent mortgage. This approach requires two sets of closing costs but gives you the flexibility to shop for the best permanent rate once your home is finished.
Typical Loan Terms and Rates
Construction loans are generally structured as 12-month terms, though some lenders offer 18- or 24-month terms for larger or more complex projects. Interest rates are typically variable during the construction phase, often tied to the prime rate plus a margin. Expect construction loan rates to run 1–2 percentage points higher than conventional mortgage rates, reflecting the increased risk to the lender.
Down payment requirements are typically higher than conventional mortgages — most lenders require 20–25% down, though some programs (including FHA and VA construction loans) allow lower down payments for qualifying borrowers.
What Lenders Look For
Qualifying for a construction loan requires more documentation than a standard mortgage. Lenders will want to review your credit score (typically 680 or higher), debt-to-income ratio, income and employment history, and financial reserves. Beyond personal financial qualifications, you'll also need to provide detailed construction plans and specifications, a licensed and insured general contractor with a proven track record, a realistic construction budget with contingency reserves (typically 10–15%), and a signed construction contract.
The lender's underwriting process evaluates not just your ability to repay but also the viability of the construction project itself. A well-documented project with an experienced contractor significantly improves your chances of approval.
The Role of the General Contractor
Your general contractor plays a central role in the construction loan process. Most lenders require that you use a licensed, bonded, and insured GC rather than acting as your own builder (though owner-builder loans do exist). The lender will review the contractor's credentials, references, and financial stability as part of the underwriting process. A strong contractor relationship is one of the most important factors in a smooth construction loan experience.
From Approval to Completion
The construction loan process typically follows this sequence: pre-qualification, full application and underwriting, appraisal of the completed home's projected value, loan approval and closing, construction begins with draws released at each milestone, and finally conversion to permanent financing or payoff. The entire process from application to the first draw typically takes 45–90 days, so plan accordingly when setting your construction timeline.
Once you have your financing in place, use Custom Home Advisor to find and compare builders in your area.