A construction loan example is the clearest way to see how this kind of financing actually works: instead of receiving the full loan at closing, you get the money in stages tied to building milestones, and you pay interest only on what’s been released so far. Take a $500,000 project financed with a $400,000 loan at 7% interest over a 12-month build. Total interest paid comes out to roughly $18,200, compared with about $28,000 if you were paying on the full balance from day one. That gap, near $9,800, is the whole point of the draw structure.
The rest of this walks through that same $500,000 project step by step: how the draws are scheduled, how your monthly payment climbs as the balance grows, what has to happen before the lender releases each check, and what it takes to convert the loan into a regular mortgage once the house is done.
The Setup: A $500,000 Project
Assume a total project cost of $500,000 covering land, materials, labor, permits, and a contingency reserve. The lender requires 20% down. The borrower brings $100,000 in cash or land equity, and the loan amount is $400,000. The term is 12 months at a 7.00% interest rate, which sits in the middle of the 6% to 8% range most borrowers see right now.
The lender’s underwriting was based on an “as-completed” appraisal: the appraiser estimated what the finished home will be worth using your plans, the lot, and comparable sales. That appraised value sets the ceiling on how much can be borrowed. Federal banking regulators cap the supervisory loan-to-value at 85% for one- to four-family residential construction, and most lenders hold their own exposure at 80%.1Federal Reserve. Frequently Asked Questions on Residential Tract Development Lending If the finished home appraises at $500,000 and the lender caps at 80%, the maximum loan is $400,000. Anything above that has to come from the borrower.
The Draw Schedule
The $400,000 doesn’t hit the borrower’s account at closing. It’s released in stages called draws, each one tied to a verified construction milestone. A typical five-draw schedule on this project looks like this:
- Draw 1 — Foundation and site work (20%): $80,000 released after the foundation is poured and site grading is complete.
- Draw 2 — Framing and roof (25%): $100,000 released once the structural frame and roof sheathing are in place.
- Draw 3 — Mechanical rough-in (20%): $80,000 released after plumbing, electrical, and HVAC rough-in passes inspection.
- Draw 4 — Interior finishes (20%): $80,000 released when drywall, flooring, cabinetry, and fixtures are installed.
- Draw 5 — Final completion (15%): $60,000 released after the final inspection and certificate of occupancy.
Every builder and every lender adjusts these percentages, but the pattern is close to universal: money follows verified progress, in that order.
How the Monthly Payment Grows
The borrower pays interest only, and only on the portion of the loan that has actually been disbursed. The math is simple: outstanding balance times the annual rate, divided by 12. Applied to the draw schedule above:
- Months 1–2: Only the first draw of $80,000 is outstanding. Monthly interest: $80,000 × 7% ÷ 12 = $467.
- Months 3–4: The framing draw brings the balance to $180,000. Monthly interest: $1,050.
- Months 5–7: Mechanical rough-in pushes the balance to $260,000. Monthly interest: $1,517.
- Months 8–10: Interior finishes bring the balance to $340,000. Monthly interest: $1,983.
- Months 11–12: The full $400,000 is drawn. Monthly interest: $2,333.
Total interest paid over the 12-month build under this schedule is roughly $18,200. If the full $400,000 had been outstanding from month one, interest would have run about $28,000. The draw structure saves the borrower close to $9,800, and that saving is the reason construction financing exists in the form it does. You don’t pay to borrow money that’s still sitting in the lender’s account.
What Has to Happen Before Each Draw
Each draw isn’t automatic. Three things run in the background between the builder finishing a stage and the check being cut.
Independent Inspection
Before releasing any draw, the lender sends an independent inspector to the site to verify that the completed work matches what’s claimed in the draw request. The inspector compares physical progress against the approved plans and the original line-item budget. If the framing draw request says the roof sheathing is complete but the inspector finds it half-finished, the lender funds only the verified portion or holds the draw entirely. Inspections typically take three to ten business days to schedule and complete, and builders who plan draw requests around that timeline avoid cash flow crunches.
Partial Lien Waivers
With each draw request, the lender collects partial lien waivers from every subcontractor and material supplier who was paid out of the previous draw. A lien waiver is the sub’s written confirmation that they were paid and won’t file a mechanic’s lien on the property for that work. This protects the lender’s first-lien position and protects the borrower from ending up with liens attached to a house that isn’t finished yet. One missing waiver can hold up the next draw.
Retainage
Most lenders hold back a percentage of each draw as retainage, typically 5% to 10%. That money accumulates through the build and is released only after the final inspection and borrower sign-off on completion. On the $400,000 loan with 10% retainage, that’s $40,000 the builder won’t see until the very end. The final retainage check is usually made payable jointly to the borrower and the builder.
What You Need to Qualify
Construction loans carry more risk for lenders than a regular mortgage, because the collateral is a half-built house. Underwriting standards are tighter as a result. Most conventional construction loan programs require a minimum FICO score of 680, with noticeably better rates at 720 and above. Debt-to-income generally needs to stay under 43%. Lenders want stable income, cash reserves, and a documented paper trail for the down payment.
The documentation package goes beyond a standard purchase mortgage: detailed architectural plans and specifications, a signed construction contract, proof of permits, and a line-item budget separating site prep, foundation, framing, mechanicals, finishes, permits, and a contingency reserve. Fannie Mae’s renovation lending guidelines require a contingency reserve of at least 10% of total construction costs for multi-unit properties and allow lenders to push that to 15% for larger or more complex projects; most lenders apply a similar 10% standard to single-family new construction.2Fannie Mae. HomeStyle Renovation Mortgages: Costs and Escrow Accounts
The lender also underwrites the builder. Expect requirements for a general contractor license, general liability insurance, workers’ compensation, references, and builder’s risk insurance sufficient to cover the completed home. The builder signs onto the lender’s draw process. Most lenders will not let a borrower act as their own general contractor.
If you already own the lot, the appraised value typically counts toward the down payment. An $80,000 lot on a $500,000 project can satisfy or substantially reduce the cash required at closing. Any remaining land loan balance is usually rolled into the construction loan, and your equity is the difference.
When the Build Runs Long or Over Budget
Material prices spike. Subcontractors fall behind. Weather delays the roof. Inspectors flag something that requires rework. The contingency reserve is the first cushion, but once costs push past it, the lender’s options narrow.
If remaining costs exceed remaining loan funds plus contingency, the project goes “out of balance.” The lender will typically suspend draws until the borrower injects additional cash equity to close the gap. If the borrower can’t come up with the money, construction stops. Sometimes the lender will restructure with a higher loan amount, but that means a fresh appraisal, credit committee approval, and usually tighter terms.
Schedule overruns are their own problem. Construction loans have hard maturity dates. If the house isn’t finished when the 12-month term expires, the borrower needs an extension, which is not guaranteed and comes with fees, additional inspections, and sometimes a rate bump. Building at least a two-month buffer into the construction schedule from the start is far cheaper than negotiating an extension under pressure.
Paying Off the Construction Loan
A construction loan is bridge financing. When the house is done, the balance has to be paid off or converted into a long-term mortgage. There are two ways to handle it.
Single-Close Construction-to-Permanent
A construction-to-permanent loan, sometimes called a one-time close, wraps the construction phase and the permanent mortgage into a single transaction. You close once, before construction begins, and the loan automatically converts to a standard 15- or 30-year mortgage when the build is complete. The permanent rate can be locked at application for periods running from 30 to 360 days, and many lenders offer a float-down provision so the rate adjusts downward if market rates drop during construction. The biggest advantage is avoiding a second set of closing costs, which typically run 2% to 5% of the loan amount.
Two-Close Process
The alternative treats the two loans as separate transactions. You close the construction loan first, build the house, and then apply for a brand-new mortgage to pay it off at maturity. You go through underwriting twice and pay closing costs twice. The upside is flexibility: you can shop multiple lenders for the permanent rate after the house is finished. Borrowers who expect rates to fall or whose financial picture will improve during the build sometimes accept the extra cost for that option.
What Has to Happen at Conversion
Either way, converting the loan requires a few things in quick succession. The lender orders a final inspection confirming the home is 100% complete per approved plans. The local building department issues a certificate of occupancy. The lender obtains an appraisal update, typically on Fannie Mae Form 1004D, confirming the finished home matches what was projected. If that update shows the value has declined since the original appraisal, the lender must order a new full appraisal and requalify the borrower at the updated loan-to-value ratio.3Fannie Mae. Conversion of Construction-to-Permanent Financing: Single-Closing Transactions
If permanent financing falls through because rates moved, your finances changed, or the appraisal came in low, the construction lender can demand full repayment of the outstanding balance. At that point the options shrink to an expensive bridge loan, a hard-money lender, or selling the property before you ever move in. That risk is why most borrowers building a primary residence choose the single-close structure and lock the permanent rate early.