A construction loan is a short-term loan that finances the building of a house, releasing money to your builder in stages as the work gets inspected rather than in one lump sum at closing. Understanding how construction loans work means understanding three things: the loan runs for roughly 6 to 18 months while the house goes up, you pay interest only on the portion that’s actually been drawn, and when construction ends the debt either converts to a permanent mortgage or gets paid off by a new one. Lenders treat these loans as higher risk because the collateral doesn’t exist yet, so qualification is stricter, documentation is heavier, and rates run higher than on a standard purchase mortgage.
The Two Basic Structures
Before anything else, you choose between two structures, and that choice shapes the paperwork, the costs, and what happens at the end.
A single-close construction loan, also called a construction-to-permanent loan, combines the building phase and the long-term mortgage into one set of documents. You close once, pay one set of closing costs (generally 2% to 5% of the total loan amount), and the loan converts automatically to a permanent mortgage when construction wraps up.1Fannie Mae. Conversion of Construction-to-Permanent Financing: Single-Closing Transactions Permanent terms, such as a 30-year fixed rate, are set before the first shovel breaks ground, and you can lock the permanent rate at that initial closing to protect yourself from rate increases during the build.2Fannie Mae. Single-Closing Construction-to-Permanent Lender Fact Sheet
A stand-alone construction loan covers only the building phase. These loans typically run 6 to 18 months, long enough for most single-family projects but short enough to keep the lender’s risk window narrow.3Fannie Mae. Two-Closing Construction to Permanent Financing Transaction Process When the home is finished, you apply for a brand-new mortgage to pay off the construction debt. That second closing brings its own fees, a new appraisal, and a fresh round of underwriting. The payoff is flexibility: you shop for the best permanent rate after the house is built. The risk is that rates or your financial picture change between the two closings.
What It Takes to Qualify
Construction loan underwriting is more demanding than approval on a standard mortgage because the lender has to evaluate both you and the project.
On the personal side, Fannie Mae’s automated underwriting system accepts debt-to-income ratios up to 50%, while manually underwritten loans cap at 36% to 45% depending on credit score and cash reserves.4Fannie Mae. Debt-to-Income Ratios Many lenders prefer a credit score of at least 680 for competitive construction loan rates, though the Fannie Mae minimum is lower.
On the project side, you’ll need to produce:
- Architectural blueprints and floor plans, which the lender’s appraiser uses to estimate the finished home’s value and set the maximum loan amount.
- A detailed line-item budget, sometimes called a pro forma, listing every projected cost from foundation to fixtures. The builder usually prepares it; the lender checks each line against current material and labor costs.
- A construction timeline showing start and end dates for each phase, confirming the work fits within the loan term.
- A signed construction contract spelling out the agreed price, whether a fixed amount or a cost-plus arrangement where the builder charges actual costs plus a markup.
Most lenders also require a contingency reserve of 5% to 10% of the total project budget built into the loan, covering surprises like a lumber price spike or unforeseen site conditions. If your budget doesn’t include that cushion, the lender will add one. Any portion of the contingency that goes unused stays undrawn and doesn’t accrue interest.
How the Money Actually Gets Released
Once the loan closes, the lender doesn’t hand over all the money at once. Funds are released in stages, called draws, tied to specific construction milestones. Common stages include site preparation, foundation, framing, roofing and exterior enclosure, mechanical systems (plumbing, electrical, HVAC), and final interior finish work.
To receive each payment, the builder submits a draw request certifying that a specific phase is complete according to the budget. The lender then sends an inspector to confirm the work matches the plans and meets quality standards. If the inspector finds incomplete or substandard work, the lender withholds the draw until the builder corrects it. That protects both you and the lender by keeping the disbursed funds proportionate to the actual value of the work in the ground.
Once an inspection passes, funds are typically wired to the builder within a few business days. The cycle repeats until the home is finished and the final draw is released.
Retainage
Many lenders withhold a percentage of each draw, commonly 5% to 10%, until the entire project is complete. This holdback, called retainage, gives the builder a financial incentive to finish the last punch-list items and ensures money is still available to correct defects discovered at the final walkthrough. The retainage is released after the final inspection and any required corrections.
Interest-Only Payments During the Build
While the house is being built, you make interest-only payments on the funds that have actually been disbursed, not on the full loan amount. If your total loan is $400,000 but only $80,000 has been drawn for the foundation and framing, interest is calculated on that $80,000. As each new draw is released, your monthly payment rises slightly because the outstanding balance grows. The structure keeps payments manageable during construction, which matters if you’re also paying rent or a mortgage on your current home.
Construction loan interest rates are almost always variable, typically set at a margin above the prime rate (for example, prime plus 1%). Because the prime rate can shift during the build, your monthly interest payment can change even between draws. These interest-only payments continue until the project reaches completion and the loan either converts or gets paid off.
Down Payment and Land Equity
The minimum down payment depends on the loan type. Conventional single-close construction loans sold to Fannie Mae can go up to 95% loan-to-value on a primary residence, meaning as little as 5% down.5Fannie Mae. Construction-to-Permanent Financing: Single-Closing In practice, many lenders set their own minimums higher, with 10% to 20% being common, because construction risk makes them more conservative than they’d be on a standard purchase. Government-backed options exist for borrowers who qualify through FHA, VA, or USDA programs, each with its own eligibility rules and down payment minimums.
If you already own the land where the house will be built, many lenders will count your equity in the lot toward the down payment. If the lot is worth $80,000 and your total project cost is $400,000, that land equity covers 20% of the loan amount. The lender will order an appraisal of the lot to confirm its current value before applying the credit.
Builder Requirements and the Owner-Builder Question
Lenders don’t just underwrite you; they underwrite your builder. Before approving the loan, the lender verifies that your general contractor holds a valid license, carries general liability insurance, and has a track record of completed projects. Many lenders review a formal contractor qualification statement covering the builder’s financial stability, past work, and references.
If you’re thinking about acting as your own general contractor to save money, know that most lenders, especially those offering FHA and VA one-time close loans, will not allow it. Self-builds, builds managed by a family member, and builds where your employer serves as the contractor are typically prohibited. The rare lenders that do allow owner-builder loans generally require you to hold a contractor’s license and show past experience managing residential construction.
If Construction Runs Late or the Builder Walks
Projects frequently run behind due to weather, material shortages, permit delays, or subcontractor availability. If the project isn’t finished before the loan term expires, you’ll need to request an extension. Extensions aren’t guaranteed. They typically come with additional fees, extended interest-only payments, and sometimes a requirement to re-qualify based on your current financial situation.
If the builder abandons the project mid-construction, you’re still responsible for the loan. The lender’s lien stays on the property, and you’ll need to find a new contractor to finish the work or negotiate a resolution with the lender. That is one reason lenders vet builders so carefully up front, and it’s also why carrying builder’s risk insurance through the construction period matters.
Cost overruns beyond the budget and the contingency come out of your pocket during the build. Whether any of that can later be rolled into the permanent loan depends on how the overrun was paid and the specific program rules.6Fannie Mae. FAQs: Construction-to-Permanent Financing
Converting to a Permanent Mortgage
The transition to permanent financing begins once the builder finishes the home and the local building department completes its final safety inspections.
With a single-close loan, the conversion happens automatically. The lender confirms the final draw is paid, verifies the completed home, and the loan shifts into its amortizing phase, where you begin paying both principal and interest on the full balance.1Fannie Mae. Conversion of Construction-to-Permanent Financing: Single-Closing Transactions The terms you agreed to at the original closing (rate, loan length, payment structure) take effect at this point. No new paperwork, no second set of fees.
With a stand-alone construction loan, you close on a completely new mortgage to pay off the construction debt.3Fannie Mae. Two-Closing Construction to Permanent Financing Transaction Process This requires a final appraisal of the completed home to confirm its value supports the loan amount. You’ll also need a Certificate of Occupancy from the local building department, certifying the structure meets safety and zoning standards and is fit for habitation. Only after that certificate is issued can the permanent mortgage be funded and the construction loan closed out. The second closing brings a new set of closing costs, new title insurance, and whatever rates the market is offering that week. If rates have dropped or your financial picture has improved since the start of the build, you may qualify for better terms than you could have locked in at the beginning.