Construction Loans Explained: How They Work

Construction loans confuse almost everyone the first time around — including experienced homebuyers. They're short-term, rate-volatile, and structured around a draw schedule instead of a single disbursement. Get the structure right and your project finances itself elegantly. Get it wrong and you'll be carrying interest reserves you didn't budget for.

The three main types

1. Construction-to-permanent (C2P)

A single loan that funds the build and then converts into a standard 30-year mortgage at completion. One closing, one set of fees. Best for owner-occupants and BTR investors who plan to hold long-term, and the most common choice for them.

2. Construction-only (stand-alone)

A short-term loan (typically 12–18 months) that funds construction only. You pay it off at completion with a separate take-out loan, sale, or refinance. Two closings, more flexibility — useful for spec builders.

3. Renovation / 203(k) loans

FHA 203(k), Fannie Mae HomeStyle, and similar products bundle purchase or refinance with renovation funds. Best for major rehabs and ADU additions on existing homes. FHA's Limited 203(k) now allows up to $75,000 of repairs.

How draws actually work

You don't get the full loan amount on day one. The lender releases funds in stages tied to construction milestones. A typical schedule:

Each draw requires inspection and lien releases from subs. Budget 5–10 business days per draw between request and funding — this is where most cash-flow problems start.

What you'll actually pay

• Interest rate: typically prime + 0.5%–1.5% during construction (variable). With the prime rate at 7.00% (October 2026), that's roughly 7.5–8.5%; rates move with each Fed decision.
• Interest-only payments during construction, calculated on the cumulative drawn amount.
• Conversion to a fixed-rate mortgage on completion (for C2P loans).
• Origination fees: typically 1–2% of the loan amount.
• Inspection fees: typically $150–$400 per draw.
• Title and recording fees per draw on some loan types.

What lenders look for

1. Credit score 680+ (720+ for best terms) for conventional and investor construction loans.
2. Debt-to-income under 45%, ideally under 40%.
3. Cash reserves of 3–6 months of payments after closing.
4. 20–30% equity (down payment + land value) for conventional and investor construction loans. Government programs differ: FHA one-time-close loans start at 3.5% down for owner-occupants (credit often around 620+), and VA and USDA (for eligible rural buyers) can offer 0% down.
5. Detailed construction budget signed by a licensed GC.
6. Builder vetting: license, insurance, references, financial statements.
7. Appraisal based on completed-value (not current land value).

Common construction loan mistakes

1. Underestimating the contingency. Build in 10–15%, not 5%.
2. Choosing a builder the lender doesn't already know — adds weeks to underwriting.
3. Forgetting soft costs (architecture, permits, surveys, impact fees) in the loan budget.
4. Locking the take-out rate too late on construction-only loans.
5. Missing draw documentation. Late lien releases hold up the whole project.

Construction-to-perm vs. stand-alone: which to pick?

If you're keeping the property, C2P is almost always cheaper because you avoid a second closing and lock today's rates for the permanent mortgage. If you're a spec builder selling at completion, stand-alone makes more sense — you don't want a 30-year mortgage you'll pay off in 60 days.