How construction loans work when building a house

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 usually show up all at once. It gets released as the house gets built.

The bank doesn’t hand your builder $400,000 on day one. It funds the project in stages, and those stages are called draws.

What is a construction loan?

A construction loan is financing used to build a house from the ground up. Instead of lending against a completed home, the lender is looking 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 over time as work gets completed. When the house is finished, the financing either converts into a traditional mortgage or the construction loan gets paid off with separate permanent financing, depending on the type of loan you chose.

That’s the basic idea.

There are two main ways to finance it

For a homeowner building a house, you’ll generally run into two broad structures.

A construction-to-permanent loan is sometimes called a single-close or one-time-close construction loan. You close once. The loan funds construction, and when the house is complete it converts into your permanent mortgage. That can simplify things, because you’re not applying for and closing on a completely separate mortgage after the build. Bankrate puts the main advantage plainly: with the construction-to-permanent approach you pay only a single set of closing costs.

A construction-only loan finances the construction period only. When the house is finished, that loan needs to be paid off, and usually that means obtaining a traditional mortgage at the end of construction. Now you’re dealing with two financing transactions, two closings and two sets of closing costs.

That isn’t automatically bad. It can give you flexibility. But it also means you still need permanent financing when the house is done.

How do construction loan draws work?

This is the part I’d understand before signing anything.

Imagine your construction contract is $400,000. The lender approves the project. That does not mean $400,000 gets deposited into an account we can freely spend. Instead there will generally be a draw schedule, something along the lines of:

• Site work and foundation
• Framing
• Roofing and dried-in shell
• Plumbing, electrical and HVAC rough-ins
• Drywall
• Interior finishes
• Final completion

The exact stages vary by lender and project. As work progresses, the builder requests money for completed portions of the project, and the lender may inspect the property to confirm the work in the draw request has actually been done before releasing funds. Draw-based disbursement and lender inspections are standard features of construction financing — Bankrate tells borrowers to expect four to six inspections over the course of a project.

A draw is not the same thing as getting paid whenever we want

This matters from the builder’s side.

Trades and suppliers still need to be paid. Materials need to be purchased. The excavator doesn’t want to wait six weeks after finishing the foundation because the lender’s paperwork wasn’t ready.

That’s why the draw schedule needs to work with the actual construction schedule. Before construction starts, I want to understand when draws can be requested, what documentation is required, how long inspections usually take, how quickly funds are released, whether lien waivers are required, who gets paid directly, and whether the homeowner needs to contribute cash before loan proceeds are used.

Those details vary by lender.

Do you make mortgage payments while the house is being built?

Usually not normal principal-and-interest mortgage payments.

During construction, many construction loans require interest-only payments on the amount that has actually been advanced so far. That structure is standard enough that federal disclosure rules are written around it — Regulation Z, Appendix D sets out how to disclose a multiple-advance construction loan where “interest is payable only on the amount actually advanced for the time it is outstanding.” Both Bankrate and LendingTree describe the same arrangement in plain terms.

Suppose you’re approved for a $400,000 construction loan and the builder has only drawn $75,000 so far. On a loan structured this way, you’re paying interest on the $75,000 that’s actually outstanding, not the full $400,000 commitment.

Then another draw happens. Now maybe $140,000 is outstanding, and your interest payment goes up with it.

That means your payment changes during construction

This is something I’d put into your personal budget.

Early in construction, relatively little money has been drawn and your interest payment may be fairly low. Near the end, most of the loan has been funded and the payment can be considerably larger.

Depending on the loan, the construction interest rate may also be different from the rate on your eventual permanent mortgage, and Bankrate notes that construction loans usually carry variable rates that move with the prime rate.

So before closing, I’d ask your lender what rate applies during construction, whether it’s fixed or variable, what the estimated payment looks like as the draws increase, and when the permanent mortgage payment begins.

What happens when the house is finished?

If you used a construction-to-permanent loan, the financing generally converts into its permanent mortgage phase once the construction requirements are satisfied. Now you begin normal amortizing mortgage payments — principal and interest, plus taxes, insurance and anything else that applies.

If you used construction-only financing, that loan has to be paid off, and usually the permanent mortgage does it. So instead of one loan transitioning into the next phase, you’re closing on another loan.

How does the bank decide how much it will lend?

The lender isn’t just looking at the construction contract. It also cares what the house is expected to be worth when it’s finished. That’s why plans, specifications and the construction budget matter.

An appraiser may evaluate the proposed home from the plans and specifications and determine an as-completed value. Then the lender applies its own loan-to-value and underwriting requirements.

That’s important, because what a house costs to build and what the bank thinks it will be worth are not automatically the same number. If you want to build a $600,000 house in an area where comparable finished homes support a much lower value, financing can get more difficult.

How much down payment do you need?

This varies substantially by lender and program — credit, debt-to-income ratio, loan size, the property, the finished value, whether you already own the land, and which loan program you’re using.

LendingTree’s current overview puts construction loan down payments commonly in the 5% to 20% range depending on the program and the borrower, with some requiring the full 20%. Bankrate makes a related point from the other direction: where a traditional mortgage might allow 3% down, a construction lender may want closer to 20%.

So I would not build a project around somebody telling you construction loans require exactly 20% down. Maybe your lender does. Another may not.

If you already own the land, it may help

This is one of the useful parts of owning your building lot before construction.

Depending on the lender and how much equity you have in it, the land’s value may count toward your equity in the total project. Say you own a $50,000 lot free and clear. You’re not necessarily starting from zero when the bank evaluates the completed project.

Exactly how land equity gets treated depends on the lender, so that’s another conversation to have before making assumptions about how much cash you’ll need.

What if you still owe money on the land?

That’s not necessarily a problem either. The construction lender may be able to incorporate the existing land debt into the transaction depending on the loan structure.

But now there are additional numbers to account for: what you owe, what the land appraises for, how much total equity exists, what the finished house is expected to be worth and how much the lender is willing to finance.

Don’t design a $500,000 house assuming the land doesn’t affect the loan.

The builder has to qualify too

This surprises homeowners sometimes. You might be financially qualified. That doesn’t mean the bank is ready to fund a project with any builder you choose.

Construction lenders want information about the builder and the project, because they’re depending on that builder to turn the loan proceeds into a completed piece of collateral. Bankrate and LendingTree both describe the same list: a contract with a licensed builder including detailed pricing, the plans and specifications, the project budget and schedule, plus the builder’s credentials, licensing, insurance and references.

Why does the bank care so much about the budget?

Because the loan has to get the house finished.

Imagine the bank lends against a $400,000 construction budget. We get 75% through the project. Then everyone realizes the house really costs $500,000. That’s a serious problem. The lender doesn’t want a partially completed house sitting on the lot with no money left to finish it. Neither do you. Neither do I.

That’s why construction loan budgets need considerably more detail than “build house, $400,000.”

This is where allowances matter

A construction contract may contain allowances for things that haven’t been finally selected yet — cabinets, flooring, tile, lighting, plumbing fixtures, maybe appliances. An allowance is a budget placeholder.

If the contract includes $15,000 for cabinetry and you choose $25,000 of cabinetry, the extra $10,000 has to come from somewhere. The construction loan doesn’t magically increase because you picked nicer cabinets. Depending on the lender and the remaining project equity, you may need to fund that difference yourself.

That’s why allowances need to be realistic. A builder can make a project price look wonderful by putting artificially low allowances in it. Then you start making perfectly normal selections and discover you’re $40,000 over budget.

What happens when you make changes during construction?

This matters even more with a financed build.

You decide to add the covered porch, upgrade the cabinets, finish another bathroom, make the garage bigger, change the flooring, move a wall. Maybe the change costs $20,000. The builder can price the change. But the bank still has to be part of the financial reality.

Some changes may be funded through remaining contingency or loan proceeds if the lender permits it. Others may require the homeowner to bring cash. The lender may also care whether the change affects the appraised finished value or the approved plans.

Contingency matters even more when you’re borrowing

I like having some room in a construction budget. Not because I assume everything will go wrong, but because you’re building a house on a piece of land, and there are variables: site conditions, material changes, small design decisions, things that genuinely weren’t visible earlier. And sometimes owners simply change their minds.

If the financing is stretched to the absolute maximum with no cash reserve and no room in the budget, every little issue becomes stressful.

That’s true whether you’re paying cash or borrowing. It’s especially true when a lender is controlling the draws. We go through this in more detail under construction contingencies.

The bank may inspect before releasing money

This isn’t the same thing as a municipal code inspection. They serve different purposes.

A municipal inspector is looking at compliance with applicable building requirements. A lender’s draw inspection is there to verify that the work represented by the draw request actually exists and has progressed far enough to justify releasing money.

So you could have both happening throughout construction. The electrician may need an inspection for the electrical work. Separately, the lender may send someone out before releasing the next draw.

How many draws are there?

It depends on the lender. Bankrate tells borrowers to expect roughly four to six inspections over a typical project, and lender draw schedules generally track the major construction stages. Some lenders use more stages, some fewer.

What I care about from the builder’s side is whether the draw schedule reasonably matches the way the house is actually being built. Foundation, framing, rough mechanicals, drywall, finishes, final — fine. We can plan around that.

What if a draw is delayed?

Construction does not stop costing money because the bank is slow.

Suppose a trade finishes $25,000 worth of work. We submit the draw. The lender needs paperwork. Then an inspection. Then something else. Then funds. If that takes two weeks, somebody is financing that two-week delay. Maybe the builder. Maybe the trade. Maybe you.

Ask how the lender handles draws before you choose the lender. I would absolutely ask other builders or borrowers what that lender’s process is actually like.

What about deposits and material orders?

Some materials require deposits before they’re manufactured or delivered — windows, cabinets, special-order materials, other major items. But the lender’s draw system may be based primarily on work or materials already completed or delivered.

That can create cash-flow questions. Who funds the deposit? Will the lender advance against stored materials? Does the homeowner need to cover it temporarily? Does the builder?

There’s no universal answer.

Do you need to sell your existing house first?

Maybe. Maybe not. This becomes a personal financing question.

If you’re currently carrying a mortgage and planning to build, the lender may consider that existing debt when qualifying you. Maybe you’re selling first and renting during construction. Maybe you can carry both. Maybe you’re using equity from your current house toward the build. Maybe a bridge or other structure enters the conversation.

Building a house while owning another house can mean carrying the current mortgage, construction loan interest, taxes, insurance and temporary housing all at once.

What if the house appraises low?

This is one of the bigger risks to understand.

Imagine land plus construction plus other financed project costs total $500,000, and the completed appraisal comes in at $450,000. The lender isn’t going to ignore that $50,000 difference because the builder’s contract says the house costs $500,000. Depending on the loan structure and the lender’s requirements, you may need more equity or cash to make the deal work.

That matters particularly when you start adding highly personalized upgrades that cost a lot but don’t necessarily produce equivalent appraised value.

Construction loans and custom homes go hand in hand

The more custom the house becomes, the more important this process is, because decisions move the budget.

Custom cabinetry. Expensive windows. Complicated tile. Large covered porches. Specialty mechanical systems. Custom millwork. Those selections can be great. But you need a financing plan capable of supporting them.

When should you talk to a construction lender?

Before you design the final house. Not necessarily before you’ve thought about what you want, but early. I’d want to know how much you can comfortably borrow, how much cash you need, how your land is being treated, what the loan-to-value requirement is, how draws work, what builder documentation is required, what rate applies during construction, when the permanent rate locks, and what happens if construction runs longer than expected or the budget changes.

Then we can design something inside reality.

Questions I’d ask a construction lender

Before choosing one, I’d ask:

• Do you offer construction-to-permanent loans, construction-only loans, or both?
• How much down payment or equity do you require?
• Can my land equity count toward that requirement?
• How do you determine the finished value?
• What documentation do you require from the builder?
• What is the construction interest rate, and is it fixed or variable?
• When and how is the permanent mortgage rate determined?
• How many draws do you use, and what triggers each one?
• Who orders the draw inspections?
• How long does a normal draw take to fund?
• How are deposits for long-lead materials handled, and do you fund stored materials?
• How do you handle change orders?
• What happens if the project goes over budget? Is there a contingency requirement?
• What happens if construction runs beyond the loan’s original term, and what does extending it cost?
• If it’s a two-close loan, what happens if rates or my financial situation change before permanent financing?

That’s a lot of questions.

One-time close or two-time close?

I’d look hard at the one-time-close option, because there’s something appealing about having the permanent financing lined up at the beginning and avoiding another full closing later. Bankrate’s summary is that the main benefit of construction-to-permanent is combining the two phases into one transaction and one set of closing costs, while construction-only financing still requires another mortgage to pay the construction debt off.

But I wouldn’t choose it automatically. I’d compare interest rates, closing costs, rate-lock options, down payment requirements, flexibility, the lender’s draw process, the loan terms, and how comfortable I am with the lender.

Construction financing should be boring

This is probably my biggest takeaway. Building the house is complicated enough. I don’t want the money becoming an adventure too.

We should know where the money is coming from, when it gets released, what documentation is needed, who’s responsible for what, what happens when something changes, and what the permanent loan looks like when we’re finished. Then everybody can focus on building the house.

So how does a construction loan work?

The simple version.

1. You qualify for the overall project. The lender reviews you, the property, the plans, the budget, the builder and the expected finished value.
2. You close on the construction financing. Depending on the product, this may also establish your permanent mortgage.
3. Construction starts.
4. The builder requests draws as work progresses.
5. The lender verifies progress and releases funds.
6. You generally pay interest on the amount that’s actually been advanced during construction.
7. The house gets completed.
8. The construction loan either converts into your permanent mortgage or gets paid off by a separate mortgage.

That’s the system. It’s not terribly complicated once you understand it. It’s just different from buying a finished house.

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.

Common questions