Construction Loans: What Borrowers Need to Know Before Building

Building a home or commercial property from the ground up requires a different kind of financing than buying an existing property. Construction loans are specifically designed for this purpose, and they work very differently from a standard mortgage. Coventry Enterprises of America explains the structure, the costs, and the risks.

How Construction Loans Work

A construction loan is typically a short-term line of credit that funds the project in stages called draws. As construction reaches specific milestones (foundation complete, framing complete, rough mechanicals complete, etc.), the lender releases additional funds. The borrower pays interest only on the amount drawn to date, not on the full loan commitment. This makes early-stage payments lower, but they increase as more of the loan is drawn.

Construction loan terms are usually 12 to 18 months. At completion, the loan either converts to a permanent mortgage (if it is a construction-to-permanent loan) or must be refinanced. Stand-alone construction loans that require a separate permanent mortgage add cost and complexity: two closings, two sets of fees, and two approval processes.

Down Payment and Approval

Construction loans typically require higher down payments than conventional purchase mortgages, often 20 to 25 percent of the total project cost. Lenders also want to review the construction budget, the contractor's credentials and license, and the architect's plans before approving. The underwriting process is more involved than a standard mortgage because the collateral does not yet exist.

Cost Overrun Risk

Construction projects routinely cost more than initially budgeted. Material prices fluctuate, unexpected site conditions arise (poor soil, rock, existing underground utilities), and design changes add to the cost. If overruns exhaust the loan commitment, you need to contribute additional cash or find supplemental financing. Most experienced builders recommend budgeting a 10 to 15 percent contingency fund above the construction estimate.

Conversion and Rate Risk

For construction-to-permanent loans, the permanent rate is often locked at application or at the time of conversion. The lock period and terms vary significantly by lender. If rates rise during construction, a locked rate protects you; if rates fall, you may be stuck with a rate above market. Understand the rate lock terms before choosing a construction-to-permanent product.