If you already own the lot, a construction loan when you own the land uses that land as your down payment and then releases money in stages to pay the builder as the house goes up. The equity in your lot is treated the same as cash at closing. During the build you make interest-only payments on the funds that have actually been disbursed, and when the house is finished the debt either converts into a permanent mortgage automatically or gets paid off by a separate mortgage you take out at that point.
Your Land Counts as the Down Payment
Before approving the loan, the lender orders an appraisal of your lot. The appraised value, minus anything you still owe on a land acquisition loan, is your equity. That equity does the job cash normally does at closing.
A quick example: if the lot appraises at $120,000 and you owe $30,000 on it, you have $90,000 in equity to put toward the project. Conventional construction loans generally ask for 5 to 20 percent down, depending on your credit profile and the lender’s guidelines. FHA single-close construction loans can go as low as 3.5 percent down, and VA construction loans may require nothing down for eligible veterans. If your land equity already clears the required percentage, you may owe nothing out of pocket at closing.
There is a ceiling on how far equity can take you. Federal banking regulators cap financing for one-to-four-family residential construction at 85 percent of the finished home’s projected value.1Federal Reserve. FAQs on the Calculation of Loan-to-Value Ratio Many lenders set their own cap tighter at 80 percent, which is where the familiar 20-percent equity figure comes from. If your land equity plus any cash doesn’t reach the lender’s threshold, you’ll need to make up the difference at closing.
One Closing or Two
The biggest structural choice you make is whether to close once or twice. It changes your closing costs, your rate exposure, and your risk if your finances shift during the build.
Stand-Alone Construction Loans
A stand-alone, or construction-only, loan covers just the building phase, usually 12 months or less. You pay interest only during construction. When the house is done, you either pay the balance off or take out a separate mortgage (the industry calls it a “take-out” loan) to replace it. That means two full applications, two sets of lender fees and closing costs, and the risk that rising rates or a change in your income makes the second loan harder to get.
Construction-to-Permanent Loans
A construction-to-permanent loan, also called a single-close loan, folds both phases into one transaction. You apply once, close once, and the construction financing automatically converts into a 15- or 30-year fixed-rate mortgage once the home is complete.2Fannie Mae. FAQs: Construction-to-Permanent Financing One closing means no duplicate title fees, appraisal charges, or origination costs. The interest rate is locked at closing, which shields you from rate increases during a long build. Some lenders offer a one-time float-down that lets you take a lower rate if the market drops before the construction phase ends.
The USDA also offers a single-close construction-to-permanent loan through its guaranteed loan program. The borrower pays interest only during construction, and the loan re-amortizes at a fixed rate for a 30-year term once the house is finished.3U.S. Department of Agriculture. Single Family Housing Guaranteed Loan Program Combination Construction to Permanent Loans
What You’ll Need to Qualify and Apply
Construction loans are riskier for lenders than standard mortgages, because the collateral doesn’t exist yet. That shows up as stricter standards and higher rates.
Most lenders want a credit score of at least 680 for a conventional construction loan, though some accept scores as low as 620 with compensating factors like a larger down payment or lower debt load. You’ll document income with pay stubs, tax returns, and bank statements. Lenders also check that your total monthly debts, including the projected mortgage, stay within acceptable limits, usually no more than 43 to 50 percent of your gross monthly income.
Interest rates on construction loans generally run one to several percentage points above standard mortgage rates. Closing costs typically fall between 2 and 5 percent of the loan amount. On a stand-alone loan, you’ll pay closing costs twice, which is a major reason borrowers lean toward the single-close option.
Documents the Landowner Specifically Brings
Because you already own the lot, part of your file is about proving that cleanly. You’ll need a copy of the recorded deed from your county recorder’s office to show you own the parcel free and clear or to confirm the remaining balance on any land loan. The deed establishes the legal description and confirms there are no undisclosed liens or title defects. Depending on location and lender, you may also need a survey, a soil or percolation test, or an environmental assessment.4Fannie Mae. Environmental Hazard Assessments
The project side of the file is just as thick. A licensed architect’s blueprints and floor plans form the basis for the as-completed appraisal. Your general contractor must provide a detailed line-item budget, often called a Schedule of Values, that breaks the total contract price into phases like foundation, framing, mechanical systems, and finishes. That budget goes with a signed builder’s contract containing the timeline and either a fixed price or cost-plus arrangement. The lender also needs the contractor’s general liability insurance certificate and, where state or local law requires one, a current contractor’s license number. The borrower application itself is the standard Uniform Residential Loan Application (Fannie Mae Form 1003).5Fannie Mae. Uniform Residential Loan Application (Form 1003)
How the Money Reaches the Builder
You don’t get the full loan at closing. A construction loan releases money in stages tied to building milestones, through what’s called a draw schedule. The schedule protects both sides from paying for work that hasn’t happened.
A typical draw schedule divides the project into five to seven phases: site preparation, foundation, framing, mechanical rough-in, insulation and drywall, finishes, and final completion. When the contractor finishes a phase, they submit a draw request with invoices for materials and labor. The lender sends a third-party inspector to verify the work matches the request before releasing funds.
You make interest-only payments during construction, calculated on the amount actually disbursed so far, not the full loan balance. Early in the build, when only a fraction of the funds have been drawn, your monthly payment is relatively small. It grows with each draw as more money is advanced. That structure keeps payments manageable while the house is uninhabitable.
Protecting the Land You Already Own
Two risks attach directly to the property during a build, and both deserve attention because you already have skin in the ground.
Builder’s Risk Insurance
Your standard homeowners policy doesn’t cover a house that’s being built. Lenders typically require a separate builder’s risk policy as a condition of closing. It covers theft of building materials, fire, vandalism, weather damage, and damage to materials in transit or storage, risks that a homeowners policy either excludes or severely limits during active construction.
The property owner usually buys the policy, though the general contractor may carry one too. A standard term for new construction is 12 months, matching the typical construction loan length. Claims during the build go against this policy rather than your future homeowners insurance, which keeps those losses off your homeowners claims history. Once the house is complete and you move in, you cancel the builder’s risk policy and switch to standard homeowners coverage, which the lender will require before converting to a permanent mortgage.
Mechanic’s Liens
If your general contractor fails to pay a subcontractor or materials supplier, that unpaid party can file a mechanic’s lien against your property, even if you’ve already paid the contractor in full. In the worst case, a lien holder can force a sale of your property to recover the unpaid amount. Because you came into the project owning the land outright, protecting it from a lien is especially important.
The defense is lien waivers. Require your contractor, and ideally each subcontractor, to sign a waiver at each draw confirming they’ve been paid for the work in that phase and giving up the right to file a lien for that amount. There are two kinds:
- A conditional waiver takes effect only after payment clears. Use it when you issue a check that hasn’t been cashed yet.
- An unconditional waiver takes effect immediately upon signing. Use it only after you’ve confirmed funds were received.
Many lenders build waiver requirements directly into the draw process and refuse to release the next round of funds until prior waivers are on file. If yours doesn’t, write the requirement into the builder’s contract. Collecting waivers at every stage is the single most effective way to keep a lien off your property after the project ends.
Budgeting for Cost Overruns
Construction projects frequently blow past their initial budgets because of material price swings, weather delays, design changes, or site surprises. Lenders account for this by requiring a contingency reserve built into the loan, typically 5 to 10 percent of the total project budget. Some advisors suggest a cushion of 15 to 20 percent if your finances allow it. Federal regulations for certain lenders specifically recognize a contingency account for unanticipated overruns as a qualifying cost in a construction budget.6eCFR. 12 CFR 723.6 – Construction and Development Loans
If costs exceed the contingency reserve, you’ll need to cover the difference out of pocket or negotiate scope changes with your builder. Lenders will not increase the loan amount after closing just because costs rose, so a realistic budget from the start matters.
When the House Is Finished
The transition to a long-term mortgage starts when the local building department issues a Certificate of Occupancy confirming the structure is safe to live in and meets code. The lender then orders a final appraisal to confirm the completed home’s value supports the total loan balance.
With a single-close loan, the conversion is mostly administrative. The lender modifies the terms, and your payments shift from interest-only on disbursed funds to fully amortized principal-and-interest payments on the total balance.3U.S. Department of Agriculture. Single Family Housing Guaranteed Loan Program Combination Construction to Permanent Loans With a stand-alone loan, you go through a full second closing, new application, new underwriting, new closing costs, to get the permanent mortgage that pays off the construction debt. The lender typically opens an escrow account at this point for property taxes and homeowners insurance, and records updated title insurance to reflect the completed improvements.
Private Mortgage Insurance
If the final loan-to-value ratio tops 80 percent, meaning you borrowed more than 80 percent of the home’s completed appraised value, the lender will require private mortgage insurance. Fannie Mae requires a primary mortgage insurance policy on any conventional first mortgage with an LTV above 80 percent, calculated using the lower of sales price or appraised value.7Fannie Mae. Provision of Mortgage Insurance PMI adds to your monthly payment but can be canceled once your equity reaches 20 percent. Because the completed home sometimes appraises higher than projected, the final LTV calculation can work in your favor.
Rate Lock at Conversion
If you chose a single-close loan, your rate was locked at closing, so the conversion rate is already set. With a stand-alone loan, you’re exposed to whatever rates are available when you apply for the permanent mortgage months later. Some lenders offer extended rate-lock programs lasting 120 to 360 days, sometimes with a one-time float-down that lets you take a lower rate if the market drops before closing. These locks usually carry an upfront fee, part of which may be credited toward closing costs.
Interest Deduction and Property Tax Reassessment
Interest paid on a construction loan can be tax-deductible, but only within specific IRS limits. The IRS treats a home under construction as a qualified home for up to 24 months, provided it becomes your main or second home once ready for occupancy. During that window, interest on the construction loan qualifies as deductible home acquisition debt, subject to the overall limit of $750,000 in mortgage debt ($375,000 if married filing separately).8Internal Revenue Service. Publication 936 – Home Mortgage Interest Deduction If construction runs past 24 months, interest in the excess period generally isn’t deductible as mortgage interest.
Expect your property tax bill to jump too. Before construction, your lot was assessed as vacant land. Once the home is complete, and in some jurisdictions during construction, the assessor reassesses the property at its improved value. Many localities issue a supplemental tax bill reflecting that higher assessment, and it can arrive months after you move in. The timing and amount vary by jurisdiction, so check with your local assessor’s office after receiving your Certificate of Occupancy so a large bill doesn’t catch you off guard.