Home Buying

Construction Loans Explained: How to Finance Building Your New Home

Building a home from the ground up is one of the most rewarding ways to become a homeowner — and one of the most financially complex. Construction loans function nothing like the mortgage you take out when buying an existing house. Instead of receiving a lump sum at closing, you draw funds in stages as your home takes shape, paying interest only on what you have drawn. Understanding this structure before you break ground can save you from costly surprises and help you budget confidently from foundation to final walkthrough.

What Is a Construction Loan?

A construction loan is a short-term, high-interest loan that finances the cost of building a residential property. Unlike a traditional mortgage — where the collateral is an existing home with a known market value — a construction loan is secured by plans, permits, and the projected finished value of a home that does not yet exist. This makes lenders significantly more cautious, which is reflected in stricter qualification requirements and higher interest rates compared to standard purchase mortgages.

Construction loans typically last 12 to 18 months, covering the time from groundbreaking to certificate of occupancy. During this period, your lender releases funds in a series of disbursements called draws, tied to construction milestones: foundation poured, framing complete, roofing done, mechanical systems roughed in, and so on. You make interest-only payments on the outstanding balance throughout — not the full loan amount — which helps keep carrying costs manageable while your home is being built.

Once construction is complete and the home passes inspection, the loan must be paid off. That repayment typically happens in one of two ways, depending on which type of construction loan you chose from the start.

Two Main Types of Construction Loans

Construction-to-Permanent Loan (Single Close)

The most popular option for owner-occupants is the construction-to-permanent loan, often called a "single close" or "one-time close" loan. Here, you apply for and close a single loan upfront that covers both the construction phase and the permanent mortgage. When your home is finished, the loan automatically converts — or "rolls over" — into a standard 30-year or 15-year mortgage with no second closing required.

The key advantages are convenience and rate certainty. You lock your permanent mortgage rate at the initial closing, protecting you from rate increases during the build. You also pay only one set of closing costs rather than two. The trade-off is less flexibility: your permanent loan terms are fixed before you know exactly what your finished home will be worth, and switching lenders after construction starts is not an option.

Stand-Alone Construction Loan (Two-Close)

A stand-alone construction loan covers only the building phase. When construction is complete, you pay off the construction loan by applying for — and closing on — a separate permanent mortgage. This two-close structure gives you more flexibility: you can shop for the best permanent mortgage rates once your home is finished and appraised. If rates have fallen since you broke ground, you benefit. If rates have risen, you bear that risk. You also pay two sets of closing costs, which can add several thousand dollars to the total transaction.

Stand-alone loans are more common when the borrower is uncertain about final loan terms, when the builder's timeline is unusually long, or when the buyer wants the option to shop lenders after construction.

How the Draw Schedule Works

The draw schedule is the backbone of a construction loan. Rather than releasing the full loan amount at closing, your lender holds the funds in a construction escrow account and releases them in tranches as your builder hits specific milestones. A typical residential draw schedule might look like this:

Draw 1 (10–15%): Site preparation, foundation, and slab.
Draw 2 (15–20%): Framing, roof structure, and exterior sheathing.
Draw 3 (15–20%): Roofing, windows, and doors installed.
Draw 4 (20–25%): Rough plumbing, electrical, and HVAC mechanicals.
Draw 5 (15–20%): Insulation, drywall, and interior finishes.
Draw 6 (10–15%): Final finishes, fixtures, landscaping, and certificate of occupancy.

Before each draw is released, the lender typically sends an inspector to verify that the work described has actually been completed. This protects both you and the lender from disbursing funds for work that has not been done. Your builder must generally submit a draw request with supporting documentation — invoices, lien waivers from subcontractors — before the lender will approve the disbursement.

You pay interest only on the cumulative drawn balance, not on the full loan commitment. If you have a $400,000 construction loan and only $100,000 has been drawn, your monthly interest payment is calculated on $100,000. Carrying costs start low and rise as the build progresses — an important cash flow dynamic to plan for.

Qualification Requirements

Credit Score

Construction loans carry stricter credit requirements than standard mortgages. Most lenders require a minimum FICO score of 680 to 720, with some conventional construction loan programs setting the floor at 620 but pricing aggressively for scores below 700. Jumbo construction loans — for homes above the conforming loan limit — typically require 720 or higher.

Down Payment

Expect to put down 20% to 25% of the total project cost, which includes land, construction costs, and contingency reserves. Some lenders accept 10% to 15% down if you have excellent credit and the project cost is well within conforming limits, but 20% is the most common threshold. If you already own the land, its current market value may be counted toward your down payment equity contribution — a meaningful advantage for buyers who purchased land separately.

Debt-to-Income Ratio

Lenders evaluate your DTI against your income using the projected permanent mortgage payment, not just the interest-only construction payment. This ensures you can afford the loan long-term once construction is complete. Most conventional construction programs cap total DTI at 45%. Use our debt-to-income calculator to model where you stand before you apply.

Builder Approval

Unlike a standard mortgage where only the borrower and the property are underwritten, construction loans also require the lender to approve your builder. Lenders vet builders for financial stability, licensing, insurance coverage, and track record. Custom home builders and general contractors who have never worked with your lender may need to submit documentation proving they are licensed, bonded, and capable of completing the project. Using an unlicensed or financially unstable builder can derail the loan entirely.

Costs to Budget For

Construction loan costs go beyond the interest payments during the build. Here are the major line items to plan for:

Interest rate: Construction loans typically carry a variable rate — often prime rate plus 1% to 2% — that is higher than fixed permanent mortgage rates. The rate applies only to drawn funds during construction, but budget for rising costs as draws accumulate.
Origination fee: Lenders typically charge 1% to 2% of the total loan commitment at closing.
Closing costs: Similar to a standard mortgage — appraisal, title insurance, recording fees, and lender charges. With a two-close loan, you pay these twice. Use our closing cost estimator to model these numbers.
Construction contingency: Most builders and lenders require a contingency reserve of 5% to 10% of the total build cost. This covers cost overruns, change orders, and unexpected site conditions. If unused, contingency funds are typically returned at the end of construction or applied to the loan balance.
Inspection fees: Each draw inspection typically costs $150 to $300. With six draws, budget $1,000 or more in inspection fees alone.
Carrying costs during build: If you are renting while your home is built, you carry both rent and construction loan interest simultaneously. This double housing cost is one of the most underestimated budget pressures for new-construction borrowers.

Before committing to a build, use our affordability calculator to stress-test your budget against both the construction period costs and the permanent mortgage payment you will carry once you move in.

The Application and Build Process

Getting a construction loan approved takes longer than a standard purchase mortgage — typically 45 to 60 days — because the lender must underwrite the borrower, approve the builder, review the construction plans and specifications, and order an appraisal based on the completed plans (called an "as-completed" appraisal). Here is the general sequence:

Select your lot and builder. Have a signed contract with your builder and a finalized set of plans before approaching lenders. Lenders cannot underwrite a vague build — they need specific plans, specifications, and a firm cost estimate.
Apply and submit documentation. In addition to standard mortgage documents (income, assets, credit), provide your builder's license and insurance, the construction contract, a detailed cost breakdown, and architectural plans.
Appraisal. The lender orders an as-completed appraisal based on your plans and local comparable sales. If the appraised value comes in below the total project cost, you may need to bring additional cash to closing or reduce your finishes budget.
Underwriting and approval. The lender reviews everything — your financials, the builder, and the appraisal — before issuing a commitment letter.
Closing. You sign loan documents, your builder can begin work, and the draw schedule takes effect.
Construction phase. Draws are requested as milestones are hit, inspections are conducted, and interest-only payments are made monthly.
Conversion or refinance. When construction is complete and the certificate of occupancy is issued, the loan converts to a permanent mortgage (single close) or you close on a new purchase mortgage (two-close).

Once your permanent loan is in place, you can use our amortization schedule to see exactly how every payment reduces your principal over the life of the loan.

Key Takeaways

Construction loans are short-term, draw-based loans that cover the cost of building a home, with interest-only payments during construction on the drawn balance — not the full commitment amount.
The two main options are construction-to-permanent (single close, one set of closing costs, rate locked upfront) and stand-alone construction loans (two closings, more flexibility on permanent loan terms).
Lenders underwrite both the borrower and the builder, requiring licensing, insurance, detailed plans, and a firm construction contract before approving the loan.
Expect stricter credit requirements (680–720+ FICO), higher down payment minimums (typically 20%), and rates above standard purchase mortgage levels.
Build a contingency reserve of 5% to 10% into your project budget — cost overruns are common, and your lender will likely require it anyway.
If you are renting during the build, double housing costs are a major budget pressure — model the full carrying cost period before committing to a build timeline.

Ready to run the numbers? Use our mortgage calculator to estimate your permanent mortgage payment once construction is complete, and our affordability calculator to make sure the total project cost fits comfortably within your long-term budget.