How Construction Loans Work: A Step-by-Step Guide for First-Time Borrowers

Construction loans vs regular mortgages

With a traditional mortgage, you're borrowing money to purchase a home that already exists and using that property to secure the debt. A lender appraises the home, you close, and the money transfers to the seller. Congratulations!

It's different with a construction loan. How it works is that your loan is secured by something that hasn't been completely built yet, which alters how the risk is perceived by the lender.

Instead of your lender sending a lump sum at closing, the funds for a construction loan get released in stages, called draws. This draw schedule is tied to specific milestones in the construction process, and before each draw is released, a lender-appointed inspector often visits the site to confirm that this work was actually completed.

You are only required to pay interest on the amount that's been drawn up to any point, rather than the full loan amount expected in the end. These interest-only payments keep your monthly costs lower during the building phase, since you're not paying on money you haven't actually received yet (or paying for a home you can't live in yet).

Another important difference is that construction loans are considered to be short-term loans in nature. They typically last from 12 to 18 months and are designed to cover your expected construction timeframe. At the end of that term, your loan either converts to a permanent mortgage or gets refinanced and paid off with a new mortgage, depending on the type of loan you have.

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Types of construction loans

Not all construction loans are the same. The one you choose affects how many times your loan closes, whether your final interest rate is locked in from the start or whether it'll change, and what happens when the building is complete.

There are two main types of construction loans that most borrowers can choose from.

Construction-to-permanent loans

A construction-to-permanent loan is sometimes called a "one-close loan." It covers the building and construction phase as well as the long-term mortgage, all in one. How this construction loan works is that you close once at the very beginning like you would any other mortgage loan, with one set of closing costs. The loan then funds your construction costs, and when building is complete and a certificate of occupancy is issued, the loan automatically converts to a regular mortgage.

The advantage of a construction-to-permanent loan is that you're able to lock in your permanent mortgage rate before construction even starts. If rates go up while you're building, you're protected with a rate lock.

On the flip side: if rates drop, you're stuck with whatever you locked in, unless you choose to refinance later.

Stand-alone construction loans

A stand-alone construction loan, also called a construction-only loan, only covers the building/construction phase of the project. When your home is complete, that loan comes due; in most cases, this means you'll apply for a separate (permanent) mortgage to pay off the debt.

Since two loans are involved, you'll have two closings and two sets of closing costs. The upside to how this construction loan works is that you can shop for the best mortgage rates once the home is actually finished, in case rates or your credit score improves while you're waiting to complete the project.

The construction loan process

Understanding how construction loans work will help you find the best possible loan at the best rates. These construction loans have more steps than a standard mortgage but are less complex than you might think. Here's what the process actually looks like.

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1. Step 1: Get pre-approved

Before talking to builders or finalizing any plans, get pre-approved for your construction loan. In underwriting, lenders will look at factors like your credit history, income, debt-to-income ratio (DTI), and assets to determine how much you can borrow. This sets your actual budget and puts you in a much stronger position when you're negotiating with builders and contractors.

2. Step 2: Lock in your builder and plans

How construction loans work is that lenders won't approve the loan without a licensed builder and detailed construction plans at hand. So, you'll need to provide things like blueprints, a line-item project budget, a build timeline, and documentation that your builder is licensed and insured.

Some lenders also want to review the builder's project history before approving the loan.

While this step feels small, it plays an important part in how construction loans work. Lenders are evaluating the project as a whole as much as the borrower.

3. Step 3: Apply

Once your plans and builder are confirmed, you'll submit your application. Expect to provide standard personal financial documents like tax returns, pay stubs, and bank statements. You'll also need to provide any construction plans, builder contracts, project budgets, or build timelines you've been given.

As part of this step in how construction loans work, your lender will order an appraisal based on the plans. This is called an "as-completed appraisal" and is the lender's estimate of what the finished home will be worth once it's all said and done.

The final loan amount is based on whichever is lower: the total project cost or the as-completed future value.

4. Step 4: Close

Once approved for your construction loan, it's time for you to close. But unlike a typical home purchase, you won't receive any money at closing.

Instead, the funds go into a construction escrow account, which is managed by the lender. You'll pay closing costs at this point, along with your required down payment; most construction loans require at least 20% down.

5. Step 5: Construction begins

Funds are then disbursed as work progresses: foundation poured, framing complete, roof on, rough electrical and plumbing done, drywall up, finishes installed. Each time a milestone is hit, your builder submits a draw request. The lender then sends an inspector to verify the milestone was actually completed. Once it's approved, the funds go directly to your builder.

How this phase of a construction loan works is that you're making interest-only repayments on whatever has been drawn so far... not the entire loan amount. So if you have a total $400,000 loan and $150,000 has been drawn, you're only responsible for paying interest on $150,000. Of course, as more is drawn, the payment grows.

6. Step 6: Construction finishes

How construction loans work at the end of the project is that when the build is complete, the builder requests the final draw and the lender does a final inspection. You'll need to get a certificate of occupancy from your local municipality, which is an official confirmation that the structure meets building code and is legally habitable.

Keep in mind that no certificate of occupancy typically means no final disbursement, so permits need to be pulled correctly throughout the entire build process. Your builder is responsible for pulling these permits at each phase for things like foundation, framing, electrical, plumbing, or HVAC. There are often inspections tied to those permits, which ensures the work gets verified along the way. If permits get skipped or inspections don't happen on schedule, it can hold up draws and delay the whole timeline.

7. Step 7: Convert or refinance into a permanent mortgage

If you have a construction-to-permanent loan, the conversion into a permanent mortgage happens automatically once the certificate of occupancy is issued. How this construction loan works is that your loan shifts from interest-only payments on draws to full principal-and-interest installments on the permanent mortgage, at the rate you locked in at the beginning.

If you have a stand-alone construction loan, this step is when you apply for your permanent mortgage. You go through the full mortgage application process again: credit check, income verification, appraisal, closing, etc. The proceeds from your new loan are used to pay off the construction loan, and the finished home is now your collateral... the same as with any traditional mortgage.

Final thoughts

Construction loans are a bit more complex than a regular mortgage, but once you get a good idea of how construction loans work, it's easy to understand why they operate the way they do. When borrowing with one, you'll get approved before anything on your new home is built. Then your builder requests funds (draws) as milestones are hit and the money get released in stages. Once a certificate of occupancy is in-hand, you'll transition to a regular mortgage, either with the same lender or a new one.

One of the most important decisions when learning how construction loans work is the type of loan you'll pick. If you're worried about rates going up during construction, a construction-to-permanent loan with a locked rate protects you. If you think rates might drop or your credit will improve, a stand-alone loan lets you shop for lower rates later on, once building is complete.