If you are building a new home, the loan process looks much different from the process for a typical mortgage. Construction loans are generally short-term loans lasting around 12 to 18 months in which the lender releases funds in stages, called draws, each tied to a specific build milestone.
When the build is done, the loan either converts to a permanent mortgage or you must pay off the balance, often with a separate mortgage. Learn more about how construction loans work, the different options available (including government-backed construction loan programs), and potential problems that could arise.
What is a construction loan?
A construction loan is a short-term loan that funds the cost of building a home from the ground up, potentially covering land acquisition, contractor labor, materials, permits, and inspections. You can use this type of loan to build a custom home on land you own or purchase or to replace an existing home with new construction.
Unlike a traditional mortgage, a construction loan finances the project before the home is complete. That added risk is why lenders often impose tighter credit and down payment requirements on this type of financing.
Construction loans often carry higher interest rates than standard long-term mortgages as well, though the difference varies by lender, loan structure, and borrower qualifications.
How construction loans work
The draw schedule
The draw schedule is the backbone of a construction loan. It’s the timeline that specifies when your lender releases money and how much each release will be.
A typical draw schedule may include milestone payments for the foundation pour, framing, mechanical rough-ins (plumbing, HVAC, electrical), drywall and insulation, and final completion. Lenders may require inspections before releasing draws.
The benefit of this structure is that you pay interest only on the amount that your lender has released, not the full loan amount. Therefore, in the early months when your lender has released only the foundation draw, your payment is relatively small. By the time your lender releases the final draw, you’re paying interest on the full balance.
The interest reserve
In some loans, the lender may establish an interest reserve by setting aside part of the loan to cover the interest-only payments while construction is underway. In other words, the lender may include additional funds in the loan specifically to help cover your payments during the build.
It’s worth noting that an interest reserve can increase your loan amount beyond the construction costs, so any balance that converts to permanent financing may be higher as well. Not all lenders allow interest reserves, however. Be sure to confirm your loan terms so you can know your cash flow and plan your budget for the next 12 to 18 months.
Types of construction loans
Construction-to-permanent loan (one-time close)
A one-time close construction-to-permanent loan is a common option for borrowers building a primary residence. You apply once, close once, and when the build is complete, the loan automatically converts to a standard long-term mortgage.
Watch for: Rate-lock rules on construction-to-permanent loans vary by lender. Some lenders let you pay a fee to lock your rate during construction, while others don’t finalize the permanent rate until later in the process. Understand exactly when your lender sets your rate, how long any lock lasts, and what it costs to extend.
Construction-only loan
A construction-only loan covers only the build phase. Once construction is complete under the loan terms, the full balance comes due. You either pay it off in cash or apply for a separate mortgage to replace it.
Consider: If rates drop during your construction period, you can shop the permanent mortgage market and potentially benefit from the lower rates. The downside is you’ll pay closing costs twice and have to qualify for both loans separately.
Owner-builder construction loans
An owner-builder construction loan is for borrowers who want to serve as their own general contractor. Lenders typically require owner-builders to hold a general contractor’s license or demonstrate equivalent documented construction experience.
Land and construction loans
A land-and-construction loan bundles the lot purchase and the build into a single loan, so you’re not juggling two separate closings.
If you already own the land free and clear, its equity can typically count toward your required down payment, which can reduce the cash you need upfront.
If you’re buying land and building in sequence, ask your lender if a combined land-and-construction loan is an option.
Qualifying for a construction loan
Construction loans often require stronger credit than standard purchase mortgages, and many lenders look for scores in the high-600s or above.
Many conventional construction loans require a larger down payment than a standard purchase mortgage, often around 20% or more, though requirements vary by lender and loan type. Compare that with minimum down payments of 3% to 5% on conventional purchase loans.
Your lender has to approve your builder, and this is a requirement many borrowers don’t see coming. Lenders vet contractors for licensing, liability insurance, and prior project history. If your preferred builder doesn’t clear the lender’s standards, you’re choosing between a new lender and a new builder.
Lenders generally require an appraisal based on the home’s projected completed value using the plans, specs, and contract details. Lenders typically base the maximum loan amount on the lesser of the cost to build or the appraised as-completed value, subject to their loan-to-value limits.
The tighter requirements reflect the lender’s extra risk since the home isn’t finished when financing begins. Approval can also take a bit longer than a standard purchase mortgage because the lender may need to review the builder, plans, specs, budget, appraisal, and permits.
Government-backed construction loans
VA construction loans
If you’re a Veteran or active-duty service member, a construction loan backed by the U.S. Department of Veterans Affairs (VA) can let you build with no down payment required.
Finding a lender that offers VA construction products may take more legwork because not all VA-approved lenders offer the construction variant. Some lenders offer VA construction-to-permanent loans that combine the construction phase and permanent financing into a single closing, but availability tends to be more limited than for standard VA purchase loans.
FHA construction loans
The Federal Housing Administration (FHA) one-time-close construction loan combines construction and permanent financing with FHA insurance backing the loan. The loan program may allow lower credit scores and down payments than many conventional construction loans.
Keep in mind that the finished home must meet HUD’s minimum property requirements, which can add friction if your builder’s specifications aren’t aligned from the start.
USDA construction loans
If you’re building in a rural area, the U.S. Department of Agriculture (USDA) Single Family Housing Guaranteed Loan Program can back a construction-to-permanent loan with no down payment required.
Property eligibility is location-driven. The property must be in a USDA-designated rural area, which may encompass more geographic area than some people realize. Check the USDA’s property eligibility map before ruling yourself out.
The real cost: a worked example
Let’s say you’ve got a $450,000 custom home project. You make a 20% down payment of $90,000 and use a construction loan for the remaining $360,000 at an interest rate of 8%. Below is a general example of how the money may flow. (Percentages reflect the loan amount.)
- Draw 1 (Foundation and slab): $72,000 (20%)
- Draw 2 (Framing complete): $90,000 (25%)
- Draw 3 (Mechanical rough-ins): $72,000 (20%)
- Draw 4 (Drywall and insulation): $54,000 (15%)
- Draw 5 (Final completion): $72,000 (20%)
After draw 1, your monthly interest-only payment is $480. After draw 3, you’ve got $234,000 outstanding and your monthly payment climbs to $1,560. Once your lender releases the final draw and the full $360,000 is outstanding, you’re paying $2,400 per month in interest. And you haven’t touched the principal yet.
When the loan converts to a 30-year permanent mortgage at 8%, the principal-and-interest payment on a $360,000 balance is approximately $2,641 per month. The jump from peak interest-only to full mortgage payment is only $241. But now part of each payment goes toward principal.
Total interest during construction depends on how quickly your lender releases funds and how long each balance is outstanding. In a scenario like this, total interest over a 12-month build could reach tens of thousands of dollars, and that needs to be in your budget alongside construction costs.
If your lender finances construction-period interest into the loan, the outstanding balance at conversion will be higher than the original construction amount. That difference increases your permanent loan balance and monthly payment.
What can go wrong
No matter how much you plan ahead or how reputable the builder is, problems can still arise with new-home construction.
- The work extends past the rate lock: If your rate lock expires before project completion, that could create some unexpected costs. For example, you may face extension fees or end up with a permanent rate that differs from what you expected at closing.
- Going over budget: If your builder goes over budget, the lender generally will not release funds beyond the loan amount for which you qualified. Borrowers may then need to cover the difference with cash, seek a change to the financing terms, or revisit the project scope.
- The builder quits mid-project: This scenario can put you in a difficult position. You remain responsible for the loan, the lender may suspend additional draws, and you may continue paying interest on released funds while the job site sits idle. Before construction begins, ask what protections are in place if the builder defaults or the project stalls. Depending on the builder and the project, that could include performance bonds, warranty protections, contingency reserves, or lender controls on draw releases.
- The project runs long: Construction loans typically require the project to be completed within the loan term. A delay that pushes past that window may require a formal loan extension, which can carry a fee or require a new appraisal.
How to shop for a construction lender
Though many borrowers mainly compare loans based on interest rate, keep in mind that with construction loans, the fees associated with the draw schedule and conversion process can add thousands of dollars to your total cost.
Before you apply anywhere, ask every lender these six questions:
- What is your draw fee per disbursement, and how many draws does your schedule allow?
- What do you charge for the inspections required before releasing each draw?
- If I choose a construction-to-permanent loan, what is the conversion fee, and will you lock the permanent loan rate today or set it at conversion?
- What happens if construction runs past the loan term? What are your extension terms and fees?
- What is your builder approval process? How long does it take, and what documentation does my builder need?
- Do you offer an interest reserve, or will I pay construction-period interest out of pocket?
The lender’s answers about extensions and interest reserves are especially important if your builder has a history of running long or if the project is complex. Get the answers in writing.
Pros and cons of a construction loan
Pros
- Build a custom home to your specifications
- Interest-only payments during construction may help make cash flow more manageable
- One-time close products offer a single closing, reducing duplicate fees and simplifying the transition from construction to permanent financing
- Government-backed options (VA, FHA, USDA) can reduce or eliminate the down payment
- Land equity can count toward the down payment if you already own the lot
Cons
- Often requires stronger credit and a larger down payment than purchase mortgages
- Rates typically run higher than standard 30-year mortgage rates
- The builder approval process adds friction and your preferred contractor may not qualify
- Rate-lock terms vary by lender and may not protect you if the build runs long
- The draw schedule controls when the lender releases funds
- You may have to cover cost overruns beyond the loan amount
The takeaway
A construction loan can be the right tool for building a home from scratch, but it’s more complex than a standard purchase mortgage. If you qualify for a government-backed option, including VA, FHA, and USDA, those loans can meaningfully reduce the barriers to entry. Start there before assuming a 20% down payment is unavoidable.
No matter which construction loan you go with, be sure you understand how draws work, budget for interest during the build, research builders and lender approval requirements before committing, and know which fees to ask about when comparing lenders. This puts you in a much stronger position than focusing on the interest rate alone.
Frequently asked questions
Are construction loans difficult to get?
Construction loans do have more stringent qualifications than a standard mortgage. They typically have higher minimum credit scores, require a larger down payment, and need lender approval for the builder and home plans.
Do I have to put down 20% on a construction loan?
If you are applying for a conventional construction loan, most lenders require 20% or more down. However, if you apply for a government-backed construction loan through the FHA, VA, or USDA, you may be able to put down less or even no money down.
How does the draw schedule of a construction loan work?
Construction loans have a draw schedule that determines when the lender releases a portion of the loan funds for each phase of the build. Draw milestones may include completing the foundation, framing, mechanical systems, drywall and insulation, and the final completion.
What happens if you go over budget when you get a construction loan?
If you go over budget and need additional funds beyond your approved construction loan amount, you may have to come up with the additional cash on your own. In some cases, you may be able to negotiate new loan terms, while some homeowners choose to scale back their project scope.
Is there such a thing as a government-backed construction loan?
Yes, there are government-backed construction loan programs for those who are eligible from the Federal Housing Authority (FHA), U.S. Department of Veterans Affairs (VA), or U.S. Department of Agriculture (USDA).