Construction Loans: How They Work and What They Cost

Construction financing is one of the most misunderstood lending products in real estate. It's fundamentally different from a mortgage — different structure, different risk profile, and different requirements. Here's how it actually works.

What a Construction Loan Is

A construction loan is a short-term credit facility (typically 12–18 months) that funds a home build or major renovation in stages, called draws. Unlike a mortgage where you receive a lump sum on day one, construction loan proceeds are released incrementally as the project reaches defined milestones.

The core logic: the lender is lending against something that doesn't exist yet (a completed building). Staged disbursement limits their exposure — they only advance funds for work that's been completed and inspected.

How Draws Work

Before closing, the borrower and lender agree on a draw schedule — typically 4–6 draw milestones tied to construction phases:

• Draw 1: Foundation complete (15–20% of loan)
• Draw 2: Framing complete and dried-in (20–25%)
• Draw 3: Mechanical rough-ins complete — plumbing, electrical, HVAC (15–20%)
• Draw 4: Insulation and drywall (15%)
• Draw 5: Interior finish and fixtures (15–20%)
• Draw 6: Final completion and certificate of occupancy (5–10%)

Each draw requires an inspection — either by the lender's inspector or a third-party inspector the lender orders. The inspector confirms the work claimed in the draw request is actually complete before funds are released. This typically adds 3–5 days to each draw cycle.

Interest is only charged on funds drawn. During construction, you're making interest-only payments on the outstanding balance. This starts small and grows as draws are taken.

Construction Loan vs. Construction-to-Permanent Loan

Stand-alone construction loan: Short-term only. When construction is complete, you pay off the construction loan with a separate permanent mortgage (conventional, FHA, VA). Requires two closings — one for the construction loan, one for the permanent mortgage. Two sets of closing costs.

Construction-to-permanent (C-to-P) loan: One loan that starts as a construction loan and converts to a permanent mortgage at completion. One closing. The permanent mortgage terms are locked at the start. Simpler administratively; requires the lender to underwrite both the construction phase and the permanent mortgage simultaneously.

Most owner-occupied new builds use C-to-P financing. Stand-alone construction loans are more common in investment and custom spec builds.

What Lenders Require

Construction lending is more demanding than conventional mortgage underwriting because the collateral doesn't exist yet.

Credit score: Minimum 680–720 for most conventional construction lenders; 700+ preferred. FHA construction loans accept 640+.

Down payment: 20–25% of total project cost (land + construction budget) for conventional construction loans. Some lenders allow 10–15% with strong credit and reserves.

Builder approval: The lender approves your general contractor — reviewing license status, insurance, financial stability, and project history. Unlicensed or financially unstable builders are a common rejection reason.

Plans and specifications: Permitted plans, specifications, and a construction budget broken down by trade. The lender's appraiser uses these to produce an "as-completed" appraisal — an estimate of what the finished property will be worth. The loan is sized to a percentage of this appraised value.

Reserves: Most construction lenders require 6–12 months of PITI (principal, interest, taxes, insurance) in liquid reserves after closing. This reflects the reality that construction projects overrun budgets.

Construction Loan Rates and Costs

Interest rates: Currently 7.5–10% on most residential construction loans. Rates are typically Prime + 1–3% and are variable during the construction period. At conversion to a permanent mortgage (for C-to-P loans), the rate often resets to a fixed rate locked at closing.

Origination fees: 1–2 points (1–2% of loan amount) is typical.

Inspection fees: $100–$250 per draw inspection, paid by the borrower.

Contingency requirement: Most lenders require a 10–15% contingency line in the construction budget. If the contingency isn't used, you don't draw it — it reduces the final loan balance.

The Biggest Risk: Cost Overruns

Construction loans are sized based on an approved budget. If costs exceed the budget, you need to cover the overage in cash — the lender doesn't automatically increase the loan. This is why contingency reserves and a conservative budget are essential, not optional.

A builder who submits a low budget to help a client qualify for the loan, then adds change orders throughout construction, is creating a financing crisis. Get your GC's budget in writing before applying for the loan and include genuine contingency.

Owner-Builder Loans

Some lenders offer owner-builder construction loans for borrowers who want to act as their own general contractor. These are harder to obtain — lenders want to see documented construction experience, and many conventional lenders won't do them at all. Expect more stringent requirements, higher reserves, and potentially higher rates. Unless you have genuine GC experience, the cost savings of owner-building are often consumed by mistakes, delays, and the financing premium.

---

Planning a construction or major renovation project and need help developing a realistic budget for financing? Schneider Construction and Development offers scope development and budget analysis available nationwide — email hello@schneidercondev.com.