What Is Construction Loan?
Construction loans bridge the gap between "no property yet" and "finished building." Unlike a traditional mortgage, you don't get one lump sum at closing. Instead, the lender releases money in draws as your contractor completes milestones—foundation, framing, rough-in, etc. You pay interest-only during construction. At completion, you either refinance into a permanent loan, convert via a built-in conversion feature, or sell. Hard money is often used for rehabs; banks and credit unions for ground-up new construction.
A construction loan is short-term financing used to fund the building of a new property or major renovation. Funds are disbursed in stages (draws) as work progresses, and the loan typically converts to a permanent mortgage or is paid off at completion.
At a Glance
- What it is: Short-term loan for building or major renovation, disbursed in stages
- Typical term: 6–18 months for construction phase
- Draw structure: Draw schedule ties funding to completion milestones
- Interest: Usually interest-only during construction
- Exit: Refinance, conversion, or sale at completion
How It Works
Why not a regular mortgage?
A traditional mortgage funds a finished, appraisable asset. During construction, there's nothing to collateralize until the project is done. Construction loans solve this by tying disbursements to verifiable progress.
The draw schedule
The draw schedule is a timeline of milestones and corresponding loan disbursements. Example for a $200,000 construction budget:
- Draw 1 (25%): Foundation complete — $50,000
- Draw 2 (25%): Framing and roof — $50,000
- Draw 3 (25%): Rough plumbing, electrical, HVAC — $50,000
- Draw 4 (25%): Finishes, final inspection — $50,000
The lender (or inspector) verifies each milestone before releasing the next draw. This protects the lender from overfunding and the borrower from paying for incomplete work.
Interest-only during construction
You only pay interest on the amount actually drawn. If you've drawn $100,000 of a $200,000 loan, you pay interest on $100,000—not the full amount. Rates run higher than permanent mortgages (often 1–3% above prime) because of the short term and construction risk.
Conversion to permanent financing
Many construction loans have a conversion feature: at certificate of occupancy, the loan automatically becomes a 15- or 30-year mortgage at a predetermined rate. One closing, one set of fees. Alternatively, you refinance with a new lender—two closings, but you can shop for the best permanent rate.
Real-World Example
Sarah is building a duplex in Austin. Land cost: $85,000. Construction budget: $280,000. Total project: $365,000. She gets a construction loan for $292,000 (80% LTV) at 8% interest-only.
Months 1–2: Foundation and slab. Draw 1: $70,000. Interest: ~$467/month. Months 3–4: Framing and roof. Draw 2: $70,000. Total drawn: $140,000. Interest: ~$933/month. Months 5–6: Rough-ins. Draw 3: $70,000. Total drawn: $210,000. Interest: ~$1,400/month. Months 7–8: Finishes and CO. Draw 4: $70,000. Total drawn: $280,000. Interest: ~$1,867/month.
At completion, the property appraises for $420,000. Sarah refinances into a 30-year fixed at 6.5%, pulling out $336,000 (80% LTV). She pays off the construction loan and has $44,000 in cash left over. Her contractor was paid on schedule via the draw schedule; the lender never advanced more than the work justified.
Pros & Cons
- Funds projects that traditional mortgages can't—no finished asset at day one
- Pay interest only on what's drawn, reducing carrying cost early
- Draw schedule aligns funding with progress, protecting both parties
- Conversion option can lock permanent rate at construction start
- Enables new construction and major rehabs without all-cash
- Higher rates than permanent mortgages
- Requires detailed budget and qualified contractor
- Delays or cost overruns can strain cash flow between draws
- Two closings if you refinance instead of convert
Watch Out
Budget accuracy: Underestimate construction costs and you'll run out of draws before completion. Add 10–15% contingency. Lenders may require a construction contingency in the loan amount.
Contractor qualification: Lenders often require an approved contractor list or specific credentials. Your cousin who "does construction" may not qualify.
Inspection delays: Draw releases depend on inspections. Schedule them promptly—delays push your next draw and increase interest cost.
Rate lock at conversion: If your construction loan has a conversion feature, understand when the permanent rate is set. Some lock at construction start; others at conversion. Rate moves can surprise you.
The Takeaway
Construction loans are the right tool when you're building or doing a major rehab. Use a realistic draw schedule, work with a qualified contractor, and plan your exit—conversion or refinance—before you break ground. The interest-only period keeps payments manageable while you're not yet earning rent.