A construction loan is not a normal mortgage with a different name.
When you buy an existing house, the house is already there. The bank lends against it, the seller gets paid at closing, and you start making mortgage payments.
When you’re building, the bank is financing something that doesn’t exist yet. So the money doesn’t show up all at once. It gets released in stages as the house gets built, and those stages are called draws.
That’s the part most homeowners need to understand before they start planning a new home.
A construction loan is financing used to build a house from the ground up. Instead of lending against a completed home, the lender looks at your finances, the land, the plans, the construction budget, the builder, the expected finished value and the project as a whole.
During construction, money is advanced as work gets completed. When the house is finished, the financing either converts into a regular mortgage or gets paid off with separate permanent financing, depending on the type of loan you chose.
Everything else is really about how the bank manages its risk while the house is being built.
You’ll generally run into two structures.
A construction-to-permanent loan, sometimes called a single-close or one-time-close loan, funds construction and then converts into your permanent mortgage when the house is done. You close once. Bankrate puts the main advantage plainly: you pay a single set of closing costs.
A construction-only loan finances the build and nothing more. When the house is finished it has to be paid off, usually with a new mortgage. That means two loans, two closings and two sets of closing costs, and your permanent rate isn’t known until the end.
That isn’t automatically bad. It can give you flexibility. I’d look hard at the one-time close, but I wouldn’t choose it automatically. Compare rates, closing costs, rate-lock options, down payment, the lender’s draw process and how comfortable you are with the lender.
The cheapest loan on paper isn’t automatically the easiest loan to build a house with.
This is the part I’d understand before signing anything.
Say your construction contract is $400,000. The lender approves the project. That doesn’t mean $400,000 lands in an account we can freely spend. There will be a draw schedule, something along the lines of:
As work progresses, the builder requests money for completed stages, and the lender usually sends someone to confirm the work is actually done before releasing funds. Bankrate tells borrowers to expect four to six inspections over a typical project. That’s a lender’s draw inspection, which is a different thing from the municipal code inspections. You’ll have both.
Here’s why it matters from the builder’s side. Trades and suppliers still need to be paid. Construction doesn’t stop costing money because the bank is slow. If a trade finishes $25,000 of work and the draw takes two weeks of paperwork and inspection to fund, somebody is financing that delay. Maybe the builder. Maybe the trade. Maybe you.
Deposits are the other pinch point. Windows, cabinets and special-order items often need money before they’re delivered, but many draw systems only pay for work in place. Who covers that gap needs an answer before we order $40,000 of windows.
A construction loan can be perfectly good financing and still create a terrible project if nobody understands how the money is supposed to move.
Usually not normal principal-and-interest payments. Many construction loans require interest-only payments on the amount that’s actually been advanced so far. That’s common enough that federal disclosure rules are written around it: Regulation Z, Appendix D covers loans where “interest is payable only on the amount actually advanced for the time it is outstanding.” LendingTree describes the same arrangement.
So if you’re approved for $400,000 and $75,000 has been drawn, you’re paying interest on $75,000. After the next draw it might be $140,000, and the payment goes up with it. Near the end, most of the loan is out and the payment is at its largest. Bankrate also notes construction loans usually carry variable rates tied to prime.
Put that into your personal budget, and confirm how your loan works. Some loans charge interest on the whole commitment.
Don’t wait until month eight to find out what the payment looks like.
The lender cares what the house will be worth when it’s finished, not just what the contract says it costs. An appraiser values the proposed home from the plans and specifications, and the lender applies its own loan-to-value limits to that as-completed value.
Those two numbers aren’t automatically the same. Say land plus construction totals $500,000 and the appraisal comes in at $450,000. The lender won’t ignore that $50,000 gap because the builder’s contract says $500,000. You may need more cash or equity to close it.
The bank doesn’t care that you love the $80,000 worth of upgrades. It cares about its collateral.
Down payment requirements vary a lot by lender and program. LendingTree puts them commonly in the 5 to 20 percent range, and Bankrate notes that where a regular mortgage might allow 3 percent down, a construction lender may want closer to 20. Don’t build a plan around a number somebody told you. Ask an actual construction lender about your actual situation.
If you already own your building lot, its value may count toward your equity in the project. A $50,000 lot owned free and clear means you’re not starting from zero. If you still owe on the land, the construction loan can often pay that off, but now the lender is weighing what you owe, what the land appraises for and what the finished house will be worth.
Land and house financing belong in the same conversation.
You might be financially qualified. That doesn’t mean the bank will fund a project with any builder you choose. The lender is depending on the builder to turn loan money into finished collateral, so it wants a contract with detailed pricing, the plans and specs, the budget and schedule, and the builder’s credentials, licensing, insurance and references. Bankrate and LendingTree describe the same list.
That’s why I’d figure out your financing route and your builder relatively early.
Because the loan has to get the house finished. If the bank lends against a $400,000 budget and we’re 75 percent through before everyone realizes the house really costs $500,000, there’s a partially built house on the lot and no money to finish it. Nobody wants that.
Three things decide whether the budget holds:
Allowances. Placeholders for things not yet chosen, like cabinets, flooring, tile and fixtures. If the contract carries $15,000 for cabinets and you pick $25,000 worth, the loan doesn’t grow to cover the difference. A builder can make a price look wonderful with artificially low allowances. Then you make perfectly normal selections and find out you’re $40,000 over.
Changes. Add the covered porch or finish another bathroom mid-build, and a signed change order doesn’t create more loan money. Some lenders let changes come out of contingency or remaining proceeds. Others will want cash from you, and they may care whether the change affects the appraised value.
Contingency. Site conditions, material changes and small design decisions happen on every house. If the financing is stretched to the maximum with no reserve, every little issue becomes stressful. More on that under construction contingencies.
The house you can comfortably finance is better than the house that only works if absolutely nothing changes.
Maybe. The lender will likely count your current mortgage when qualifying you. Some people sell first and rent during the build. Some carry both. Some use equity from the current house. Just know that building while you own another house can mean carrying a mortgage, construction interest, taxes, insurance and possibly rent all at once.
Before you design the final house. Not before you’ve thought about what you want, but early, so financing sets the guardrails instead of showing up at the end to say the house we designed can’t happen. I’d ask:
You’re borrowing hundreds of thousands of dollars. Ask them.
The simple version:
A good construction loan should mostly disappear into the background while the project happens. If we’re talking about the bank every week, something probably isn’t working.
For homeowners planning to build around Selinsgrove, Lewisburg, Sunbury, Northumberland, Shamokin Dam, Milton, Watsontown, Danville and the surrounding Central PA area, I’d get the financing conversation started early. Talking to a lender covers what to bring.
Know what you can comfortably build before we spend months designing what you can’t.
How does a construction loan work?
A construction loan finances a new house in stages rather than paying the entire loan out at once. As construction progresses the builder requests draws, and the lender typically verifies progress before releasing additional funds. Many borrowers make interest-only payments on the funds actually advanced during construction.
Do you pay a mortgage while building a house?
Usually not a normal amortizing mortgage payment. Many construction loans require interest-only payments on the amount drawn so far. After construction, a construction-to-permanent loan converts to regular mortgage payments, or separate permanent financing pays off a construction-only loan.
How much down payment do you need for a construction loan?
It depends on the lender and the loan program. LendingTree’s current overview puts construction loan down payments commonly in the 5% to 20% range, with some programs requiring the full 20%, and Bankrate notes construction lenders often want closer to 20% where a traditional mortgage might allow 3%. Credit, project value, land equity and other underwriting factors all matter.
Can land count as the down payment on a construction loan?
Potentially. If you already own the land and have equity in it, some lenders may credit that equity toward the amount you need to contribute to the project. Exactly how it’s calculated depends on the lender and the loan structure.
What is a draw on a construction loan?
A draw is a staged release of construction loan money as the house is built. The lender and builder work from an agreed draw schedule, and the lender may inspect the project before releasing funds for completed work. Bankrate tells borrowers to expect four to six inspections over a typical project.
What happens if construction goes over budget?
The loan doesn’t automatically increase. Depending on the lender, the available contingency and the remaining equity, additional costs may need to be paid by the homeowner. That’s why realistic allowances, clear change orders and some financial breathing room matter so much on a financed build.
Fifteen minutes on the phone. You’ll have a realistic range before we hang up — and if we’re not the right people for it, I’ll tell you.