What Is a Construction Loan?

Introduction

A construction loan finances building a new home from the ground up. Unlike a traditional mortgage that funds a purchase of an existing home, a construction loan releases funds in stages—called draws—as the builder completes milestones. When construction is finished, the loan may convert to a permanent mortgage (one-time close) or you may need a separate loan to pay off the construction loan (two-time close).

Construction loans are specialized products. Lenders typically require a construction contract, detailed budget, approved plans, and often a larger down payment. Your loan amount is based on the projected cost to build, and you typically pay interest only on the amount drawn during construction. Federal rules—including the Truth in Lending Act (TILA), RESPA, and TRID—apply to construction-to-permanent loans. You will receive a Loan Estimate within 3 business days of application showing the interest rate, mortgage payment (after conversion), and closing costs.

This guide explains how construction loans work, what to expect from underwriting, and how they differ from renovation loans. For related options, see What Is a Renovation Loan, What Is an FHA 203k Loan, and What Is a Conventional Loan.

What This Means

A construction loan is a short-term loan used to finance the cost of building a home. The lender does not disburse the full loan amount at closing. Instead, funds are released in draws—typically when the foundation is complete, framing is up, rough-in (electrical, plumbing, HVAC) is done, and at final completion. An inspector usually verifies each stage before the lender releases the next draw.

During construction, you typically pay interest only on the amount that has been drawn. If the total loan amount is $400,000 and only $100,000 has been drawn after the foundation and framing, you pay interest on $100,000. As more is drawn, your interest payment increases. This differs from a standard mortgage, where you receive the full loan amount at closing and begin full mortgage payments (principal and interest) immediately.

Construction loans often require a larger down payment—20–25% is common—because the lender is taking risk on a project that does not yet exist. Your loan-to-value ratio (LTV) is based on the projected completed value or construction cost. Lenders want to ensure the finished home will be worth more than the loan amount.

How It Works

When you apply for a construction loan, the lender will underwrite your application—verifying your income, assets, credit, and the construction project. You need a signed construction contract, a detailed budget (often a line-item breakdown), and approved building plans. The lender may also require a construction contingency (e.g., 10%) to cover overruns. Your debt-to-income ratio (DTI) must support the mortgage payment you will have once the loan converts to permanent financing.

With a one-time close (construction-to-permanent) loan, you close once. The loan has a construction phase and a permanent phase. When the home is complete and the certificate of occupancy is issued, the loan converts to a standard mortgage. You lock your interest rate at the initial closing, so you know your future mortgage payment. Closing costs are paid at the first closing; you do not pay closing costs again at conversion.

With a two-time close, you close on a construction-only loan first. When construction is done, you apply for a separate permanent mortgage (or refinance) to pay off the construction loan. You close again and pay closing costs a second time. The two-time close can offer flexibility—you may shop for a permanent loan when the home is complete—but it involves two rounds of underwriting and two sets of fees.

Your Loan Estimate will show the loan amount, interest rate, and estimated mortgage payment after conversion. Under TRID, you receive this within 3 business days of application. The form may also show the draw schedule and construction terms. See What Is Amortization and What Is Mortgage Principal for context on how permanent payments work.

Realistic Example Scenario

Jennifer and Tom are building a new home. The total project cost is $450,000 (land, construction, and contingency). They own the land free and clear (worth $80,000) and need $370,000 to build. They apply for a construction-to-permanent loan with a 20% down payment on the construction cost—$74,000. Their loan amount is $296,000.

They close in January. The draw schedule has five stages: 10% at foundation, 25% at framing, 25% at rough-in, 25% at drywall and finishes, 15% at final. They lock a 6.5% interest rate at closing. During construction, they pay interest only on the drawn amount. After the first two draws ($103,600), their interest-only payment is about $560 per month. By month six, when the home is complete, the full loan amount has been drawn. The loan converts to a 30-year mortgage, and their mortgage payment (principal and interest) becomes about $1,870.

Their closing costs at the initial closing were about $9,000. They did not pay closing costs again at conversion—the one-time close structure avoids a second set of fees. If they had used a two-time close, they would have paid closing costs twice—once for the construction loan and again for the permanent mortgage.

This example is illustrative. Actual interest rates, closing costs, draw schedules, and requirements vary by lender. Construction timelines can change; delays may affect when draws are released and when the loan converts.

Why This Matters for Homebuyers

If you want to build a custom home rather than buy an existing one, a construction loan is typically the financing path. It allows you to pay the builder in stages as work is completed, which protects you—the lender verifies progress before releasing funds. You are not paying interest on the full loan amount until it is drawn, which can reduce your interest cost during the build.

A one-time close construction-to-permanent loan simplifies the process: one application, one closing, one set of closing costs. You lock your interest rate upfront, so you know your future mortgage payment. A two-time close may make sense if you want to shop for the best permanent rate when the home is done—but you take the risk that rates could rise, and you pay closing costs twice.

Construction loans are different from renovation loans or FHA 203k loans, which finance buying and renovating an existing home. If you are buying a fixer-upper, those programs may be a better fit. If you are building from scratch, a construction loan is the typical option.

Pros and Cons

Common Mistakes

• Underestimating the down payment: Construction loans often require 20–25% down. Budget accordingly—you need more cash upfront than for many purchase mortgages.
• Not having a detailed budget: Lenders want a line-item construction budget. Vague estimates can delay approval or cause draw issues. Work with your builder on a detailed cost breakdown.
• Assuming you can change plans mid-build: Significant changes may require lender approval and can affect the draw schedule. Plan carefully before breaking ground.
• Ignoring the conversion rate: With a one-time close, you lock your permanent interest rate at the start. Understand what rate you are locking and for how long. Rate locks can expire if construction runs long.
• Confusing construction and renovation loans: A construction loan is for new builds. If you are buying and renovating an existing home, a renovation or 203k loan may be the right product.

Frequently Asked Questions

What is a construction loan?

A construction loan finances building a new home. Funds are typically disbursed in draws as construction milestones are met. The loan may convert to a permanent mortgage (one-time close) or require a separate closing (two-time close) for permanent financing.

How do construction draws work?

The lender releases funds in stages (draws) as construction progresses—e.g., foundation, framing, rough-in, final. An inspector usually verifies each stage before the next draw. You typically pay interest only on the amount drawn.

What is one-time vs. two-time close?

A one-time close (construction-to-permanent) combines construction and permanent financing in one loan. You close once and the loan converts when the home is complete. A two-time close has separate construction and permanent loans—you close twice.

What are typical construction loan requirements?

Lenders typically require a construction contract, detailed budget, approved plans, and often a larger down payment (20–25% is common). Credit and income requirements may be stricter than for a standard purchase mortgage.

Do I make mortgage payments during construction?

You typically pay interest only on the amount drawn during construction. Once the loan converts to a permanent mortgage, you begin making full principal and interest payments.

How is a construction loan different from a renovation loan?

A construction loan is for building a new home from the ground up. A renovation loan (e.g., FHA 203k) finances buying and renovating an existing home. Different programs and requirements apply.

Sources

• Consumer Financial Protection Bureau (CFPB) – Loan Estimate and Closing Disclosure (TRID)
• Consumer Financial Protection Bureau (CFPB) – Truth in Lending Act (TILA)
• U.S. Department of Housing and Urban Development (HUD) – RESPA
• Fannie Mae – Construction-to-Permanent Loan Programs