Why It Matters
You draw money as you build — not all at once. The lender releases funds in stages after inspecting each milestone: foundation poured, framing complete, mechanical rough-in done. You pay interest only on what's been drawn, which keeps carrying costs manageable during construction. At completion, you sell, refinance into a 30-year mortgage, or let the loan convert automatically if you chose a construction-to-permanent structure. This isn't hard money — it demands detailed plans, licensed contractors, permits, and an appraisal of completed value before any lender will approve it.
At a Glance
- What it is: Short-term interest-only loan for ground-up construction or major renovation, disbursed in draws tied to milestones
- Loan term: 6–18 months for residential builds; commercial projects up to 24 months
- Rate range: Typically prime + 1–2%, roughly 8.5–10% in a 2024–2025 rate environment
- LTC cap: Lender funds 75–85% of total project cost (loan-to-cost ratio)
- LTV on completion: Usually capped at 80% of completed appraised value
- Exit options: Sell at completion, refinance into permanent mortgage, or convert via C2P (construction-to-permanent) loan
- Required upfront: Detailed plans, permits, licensed general contractor, builder's risk insurance, appraisal of completed value
Monthly Interest = Drawn Amount × Annual Rate / 12
How It Works
Draw schedules control every dollar. You don't receive the full loan at closing. The lender releases funds in tranches tied to construction milestones — foundation, framing, mechanical rough-in, finishes, and final completion. Before each draw, the lender sends an inspector to verify work is done. You can't over-draw on unfinished work, and the lender isn't funding labor that never happened.
Interest accrues only on what's drawn. If your total loan is $300,000 but you've drawn $80,000, your monthly interest is $80,000 × rate / 12 — not the full commitment. Payments ramp up as draws accumulate, peaking in the final months before you exit. Budget for this cost escalation when projecting rehab costs and total project carry.
Construction-to-permanent vs. two-time close. A C2P loan closes once — rate locks at construction start, converts to a 30-year mortgage at completion, one set of closing costs. A two-time close uses separate loans and two closings, but you set the permanent rate after the build when you know the final appraised value. Rates falling during construction? Two-time close captures them. Rates rising? C2P's locked rate shields you.
Qualification requires more than good credit. Lenders underwrite the project, the borrower, and the builder simultaneously. Expect to provide: architectural drawings, permits, a licensed GC with a verifiable track record, a budget broken down by trade, builder's risk insurance, and a completed-value appraisal based on plans — not existing comparables. LTC caps the lender's exposure at 75–85% of total project cost; the remaining 15–25% is your equity injection.
Real-World Example
Marcus owns a lot in a secondary market and builds a duplex. Construction cost: $380,000. His lender approves an 80% LTC loan: $304,000 at 9%, 12-month term, five draws.
Draw 1 (foundation): $52,000 drawn — monthly interest $390. Draw 3 (rough-in, $185,000 drawn): $1,388/month. Draw 5 (completion, $304,000 drawn): $2,280/month.
Marcus finishes in 10 months. Total construction interest: approximately $14,600. He refinances into a 30-year DSCR loan at 7.5%. The duplex appraises at $490,000; new loan: $392,000. After retiring the construction balance, he recovers his $76,000 equity and the duplex cash flows $820/month. The cash-out refi recycles his capital back into the next build.
Pros & Cons
- Interest-only payments on drawn amounts keep carrying costs manageable during construction
- Draw inspections mean funds release only after verified work is complete — no paying for labor that didn't happen
- C2P structure eliminates a second closing, cutting transaction costs on exit
- New construction starts with no deferred maintenance and market-rate rents from day one
- Builds in undersupplied submarkets can generate equity at completion that exceeds total project cost
- Qualification is harder than a purchase mortgage — plans, permits, licensed GC, and a completion appraisal are all required
- Draw inspection delays stall contractors and extend your timeline, raising carry costs
- Cost overruns are your problem — if the build exceeds budget, you fund the gap
- Rates are higher than conventional financing, typically prime + 1–2%
- Material changes to plans or contractors require lender approval throughout the build
Watch Out
Budget a 10–15% contingency — and treat it as spent. Running out of money before the certificate of occupancy is the most common construction failure. If your lender caps at 80% LTC and your contingency isn't baked in, a $50,000 overrun means covering it out of pocket with a half-finished building you can't sell or rent. Build the contingency into your pro forma before applying.
Verify your lender actually funds construction loans. Many banks advertise it but have slow approval committees and draw processes that take two to three weeks — stalling your contractor every month. Ask local builders who closed their last construction loan and how fast draws were released. A 10-day draw turnaround is worth a quarter point more in rate.
Ask an Investor
The Takeaway
A construction loan is the right tool when you're building from the ground up or doing a renovation that a standard mortgage won't cover. Funds release in draws tied to completed milestones, interest accrues only on what's drawn, and you exit via sale, refinance, or automatic conversion at completion. Budget a contingency, choose a lender with fast draw turnarounds, and nail down your takeout financing before breaking ground — because a great build means nothing if you can't exit at favorable terms.