A construction loan is a short-term loan that pays your contractor in stages as building progresses, not all at once at closing

Unlike a mortgage, which you receive as a lump sum and repay over 15 or 30 years, a construction loan disburses money in phases—typically called "draws"—as work reaches certain milestones. You might receive 20 percent when the foundation is poured, another 20 percent when framing is complete, and so on. The lender inspects the work before each payment to confirm it matches the contract and budget.

Construction loans are shorter-term than mortgages, usually lasting 12 to 24 months. During construction, you typically pay only interest on the money already drawn, not principal. Once building finishes, the loan either converts to a permanent mortgage or you refinance into one. If you do not convert, you must repay the entire balance—which is why construction loans are rarely left open indefinitely.

Lenders treat construction loans as riskier than mortgages because the collateral (the house) does not yet exist. That risk shapes what they ask for: detailed plans, a locked contractor price, proof of land ownership, and often a larger down payment than a traditional mortgage would require.

Key Takeaways

  • Construction loans pay your contractor in stages as work progresses, and you pay interest only on the amount drawn so far, not the full loan amount.
  • Lenders require detailed architectural plans, a fixed-price contract with your contractor, proof of land ownership, and typically 20 to 25 percent down.
  • The loan term is usually 12 to 24 months; when construction ends, you convert to a permanent mortgage or refinance into one.
  • Lenders inspect the work before each draw to verify it matches the contract and budget, and they may hold back a percentage of each payment until final completion.
  • Interest rates on construction loans are typically higher than mortgage rates, and some lenders charge fees for inspections, appraisals, and loan administration.

What lenders need before they will fund a construction loan

A lender will not commit to a construction loan without seeing the full picture of the project. You will need to provide a complete set of architectural or engineering plans—not sketches, but the drawings a contractor uses to bid and build. The plans must show the finished structure, materials, and systems (electrical, plumbing, HVAC). If you are working with an architect, they produce these; if you are using stock plans or a builder's design, you still need the final version the contractor will follow.

You also need a fixed-price contract with your contractor that lists every task, material, and cost. This contract protects both you and the lender: it shows what the work should cost and gives the lender a baseline to check against during inspections. If the contractor later claims the job will cost 30 percent more, the lender can see the original agreement and may refuse to fund the overrun.

Proof of land ownership is required—a deed or title report showing you own the property free and clear, or that any existing mortgage is being paid off with construction loan proceeds. The lender will place a lien on the property to find the loan, so they need to confirm the title is clean enough to do that.

Most construction lenders require 20 to 25 percent down, paid upfront. This is higher than the 10 to 20 percent typical for mortgages. The down payment reduces the lender's risk and shows you have skin in the game. Some lenders will accept 15 percent if you have strong credit and income, but this varies by lender and market.

How draws work and what happens between them

A draw is a disbursement of loan funds tied to a construction milestone. Your lender and contractor agree in advance on what triggers each draw—foundation complete, framing complete, rough-in complete (electrical and plumbing installed but not finished), drywall complete, and so on. The number of draws varies; a straightforward project might have 5 or 6, while a complex one might have 10 or more.

When a milestone is reached, the contractor (or you) notifies the lender. The lender orders an inspection by a third-party inspector or their own staff. The inspector verifies that the work shown in the contract has actually been done and meets the plans. If the work is incomplete or does not match the contract, the lender will not release the draw until it is corrected.

Once the inspection passes, the lender releases the funds—but often not the full amount. Many lenders hold back 5 to 10 percent of each draw as a "retainage" or "holdback," releasing it only when the entire project is finished and a final inspection passes. This protects the lender if the contractor abandons the job or leaves work incomplete.

Between draws, you are responsible for paying the contractor for any work done. The contractor may ask for partial payment before the next draw is released, or they may wait. This is negotiated in your contract with them. During construction, you typically pay interest only on the amount drawn so far; if you have drawn $200,000 of a $400,000 loan, you pay interest on $200,000, not the full amount.

Interest rates, fees, and the cost of borrowing during construction

Construction loan interest rates are typically 0.5 to 1 percent higher than mortgage rates, reflecting the higher risk. If a 30-year mortgage is at 6.5 percent, a construction loan might be at 7.0 to 7.5 percent. Rates vary by lender, your credit score, the size of your down payment, and current market conditions. Rates are not fixed during construction; some lenders offer a fixed rate for the construction phase, while others tie the rate to a variable index (like the prime rate), which can change monthly.

Beyond interest, construction loans carry additional fees. Lenders typically charge an origination fee (0.5 to 2 percent of the loan amount), an appraisal fee (usually $500 to $1,500 for land or a project appraisal), and inspection fees for each draw (often $150 to $500 per inspection). Some lenders charge a loan administration fee or "servicing fee" monthly or at closing. A few charge a fee to convert the construction loan to a permanent mortgage, though many waive this if you refinance with them.

Because you pay interest only during construction, your monthly payment is lower than it will be after conversion. On a $400,000 construction loan at 7 percent, you might pay roughly $2,300 per month in interest alone during the 18-month build. Once the loan converts to a 30-year mortgage, your payment will jump to around $2,700 per month (principal plus interest), assuming rates and terms stay the same.

Construction-to-permanent loans versus two separate loans

A construction-to-permanent loan (also called a "one-time close" loan) is a single loan that automatically converts from construction to mortgage when building is complete. You close once, lock in one interest rate for both phases, and avoid a second closing and refinancing costs. This is simpler and often cheaper than taking out two separate loans.

A standalone construction loan is a separate, temporary loan that you must refinance into a mortgage when construction ends. You close twice: once for the construction loan and again for the mortgage. The second closing involves another appraisal, another set of fees, and a new interest rate (which could be higher or lower than the construction rate). Standalone loans are less common now but may be used if you are not yet ready to commit to a permanent mortgage or if your lender does not offer construction-to-permanent products.

Construction-to-permanent loans are generally the better choice because they lock in certainty. You know your permanent rate upfront and avoid the risk that rates will rise between construction completion and refinancing. However, not all lenders offer them, and some charge a higher rate for the construction phase to offset the rate lock. Compare the total cost of a construction-to-permanent loan against a standalone construction loan plus a separate mortgage to see which is cheaper for your situation.

What can go wrong and how lenders protect themselves

Construction projects frequently run over budget or behind schedule. A contractor may encounter unexpected soil conditions, supply chain delays, or labor shortages. If costs exceed the original contract, the contractor will ask for more money. If you do not have reserves, you may need to ask the lender for additional funds—which the lender may refuse if the overrun is large or if the project is already behind schedule.

Lenders protect themselves by requiring a contingency reserve, usually 10 to 20 percent of the total project cost, held in an escrow account. This reserve covers unexpected costs without requiring a new loan or a change to the draw schedule. You fund this reserve upfront, and the lender releases it only if the contractor and lender agree the overrun is legitimate.

Lenders also protect themselves through the inspection process and the retainage holdback. By inspecting before each draw, they confirm the work is real and matches the contract. By holding back a percentage of each draw, they may support the contractor has incentive to finish the job and correct any defects. If the contractor walks away, the lender can use the retainage to hire another contractor to complete the work.

If you stop paying interest during construction or if the project stalls, the lender can foreclose on the property, just as they would with a mortgage. This is rare but possible, which is why it is critical to have a realistic budget, a reliable contractor, and a clear understanding of your own financial capacity to cover overruns.

Comparing construction loans to other ways to pay for building

A construction loan is not the only way to finance a new build. Some people pay cash, which eliminates interest and lender fees but ties up capital that could be invested elsewhere. Others use a home equity line of credit (HELOC) against an existing home, which is simpler to obtain but offers no protection if the project fails and you still owe the balance. A few use a personal loan or contractor financing, though these typically carry higher interest rates and smaller loan amounts.

A construction loan is usually the cheapest and most structured option if you are building a substantial home or commercial structure. It spreads the cost over time, ties disbursements to actual progress, and gives the lender (and you) visibility into the project's health. The trade-off is complexity: you need detailed plans, a solid contractor, and the discipline to manage the project and the loan together.

Frequently Asked Questions

Can I get a construction loan if I do not own the land yet?

Most lenders require you to own the land or have it under contract before they will fund a construction loan. Some lenders will fund the land purchase and construction together in a single loan, but this is less common. If you are buying land and building, ask your lender whether they offer a "land and construction" loan or whether you need to close on the land first.

What happens if construction takes longer than expected?

If the project runs past the loan term (usually 12 to 24 months), you will need to extend the loan or refinance. Most lenders allow one or two extensions, usually for 6 months at a time, but charge an extension fee (typically $500 to $1,500). If you need a longer extension, the lender may require a new appraisal and may adjust the interest rate. Plan for delays and discuss extension options with your lender before you close.

Do I have to use the contractor the lender recommends?

No. You choose the contractor, but the lender may require the contractor to meet certain standards—a valid license, insurance, bonding, and a clean record with the state licensing board. The lender will verify these before approving the loan. If your contractor does not meet the lender's standards, you will need to find a different one or ask the lender to make an exception.

What if I want to make changes to the plans during construction?

Changes are possible but costly and slow. Any change to the plans must be approved by the lender before the contractor starts the work. The lender will order a new inspection and may require a change order from the contractor showing the new cost. If the change increases the total project cost beyond your loan amount, you will need to fund the difference yourself or ask the lender to increase the loan (which may not be possible). Avoid changes if you can; they delay draws and add fees.

What is the difference between a construction loan and a construction-to-permanent loan?

A construction loan is temporary and must be refinanced into a mortgage when building is done. A construction-to-permanent loan is a single loan that automatically converts to a mortgage at completion, with no second closing or refinancing. Construction-to-permanent loans are simpler and usually cheaper because you close once and lock in one rate for both phases.