Construction loans advance funds in stages while a home is built or renovated. They are usually interest-only during construction, involve stricter underwriting and higher upfront equity, and come as either construction-to-permanent (one-time close) or standalone loans. Shop lenders, confirm draw and inspection terms, and budget contingencies for overruns.

What a construction loan covers

A construction loan provides short-term financing to build a new home or carry out major renovations. Lenders advance funds in stages (called draws) as work is completed. Typical costs covered include labor, framing and exterior materials, roofing, interior finishes, and required site work. Lenders usually require detailed plans, a builder contract, and a budget before approving funds.

How payments and draws work

Most construction loans are interest-only during construction. You pay interest on the amount disbursed at each draw; principal repayment generally begins only after the project converts to a permanent mortgage. Lenders inspect progress before releasing each draw and may hold a retention amount until final completion.

Loan types: one-time close vs. standalone

Two common structures exist:

  • Construction-to-permanent (one-time close): The loan finances construction and automatically converts to a mortgage when the home is finished. It simplifies closing costs and underwriting.
  • Standalone construction loan (two-close): You close one loan for construction, then close a separate permanent mortgage when construction ends.
Which is best depends on your timeline, cash reserves, and lender offerings.

What lenders look for

Lenders assess the borrower's credit, income, and debt-to-income ratio, plus the builder's experience, plans, and cost estimates. Expect more documentation and stricter underwriting than for a standard mortgage.

Down payments and equity requirements are typically higher than with standard home loans. Lenders also expect a contingency budget for cost overruns.

Interest rates, terms, and risks

Construction loans are short-term and often carry higher rates than long-term mortgages. Many lenders price these loans on short-term benchmarks (lenders have moved away from LIBOR to alternatives such as SOFR) or on the lender's prime rate. Interest-rate behavior can vary, so ask how your rate is determined and whether you can lock a rate for the permanent mortgage.

Typical terms are short (commonly 6-18 months), and projects that run long can face higher costs or require refinancing. 1

Alternatives and practical tips

If building or renovating feels risky, compare alternatives: home equity lines of credit (HELOCs), cash-out refinances, or renovation-specific products such as FHA 203(k) and Fannie Mae HomeStyle Renovation loans. A contingency reserve (commonly recommended at 10%-20% of construction costs) helps absorb material-price swings and delays. 2

Before you sign: get multiple lender quotes, verify the builder's references, confirm the draw schedule and inspection process, and budget conservatively for delays and cost increases.

A construction loan can make a new home or major renovation possible, but it requires planning, clear budgets, and a lender comfortable with construction financing.

  1. Confirm common lender benchmarks for pricing construction loans (e.g., use of SOFR or prime) and how widely SOFR is used for construction products.
  2. Verify typical construction loan term ranges (6-18 months) offered by most lenders.
  3. Confirm recommended contingency percentage range (commonly cited as 10%-20%) for residential construction projects.

FAQs about New Construction Loan

What is a construction-to-permanent (one-time close) loan?
A one-time close loan funds construction and then converts automatically to a permanent mortgage when the project finishes, avoiding a second closing and potentially saving on fees and underwriting.
How do lender draws work?
Lenders release funds in stages based on completed work. They typically require inspections before each draw and may retain a portion of each payment until final completion.
Are construction loans interest-only?
Most construction loans require interest-only payments on the disbursed amounts during construction; principal payments usually start after conversion to the permanent loan.
What should I budget for contingencies?
You should include a contingency reserve to cover overruns and material-price volatility. A common recommendation is to budget a percentage of the project cost as contingency.

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