Construction Loans Explained: How New Home Financing Actually Works

A traditional mortgage works because there is already a completed house to use as collateral. The lender values the property, loans against that value, and holds a lien until you pay it off. New construction does not work this way. At closing, all you have is a lot and a set of plans. The house does not exist yet.

Construction loans are designed for this situation. They disburse money in stages as the work progresses, with the lender inspecting the property at each milestone before releasing the next draw. This structure protects the lender — they are never very far ahead of the value of what has been built — and it also protects the borrower from a contractor who builds slowly while holding large sums of the owner's money.

A construction-to-permanent loan (also called a one-time close or OTC loan) combines the construction financing and the permanent mortgage into a single loan product. You apply once, close once, and the loan automatically converts to a standard mortgage when construction is complete. The main advantage is simplicity and the elimination of a second set of closing costs.

A stand-alone construction loan is a short-term loan (typically 12–18 months) that covers only the build phase. When construction is complete, you pay it off by taking out a separate permanent mortgage. The double-close process means two sets of closing costs but also more flexibility: you shop for your permanent mortgage at close-out, when your actual build cost and completed home value are known. In a rising rate environment, this is a risk; in a stable or falling rate environment, it is often the better deal.

Construction loan underwriting is more demanding than purchase mortgage underwriting. Expect lenders to scrutinize your credit score (740+ for the best terms, though 680+ is often workable), your debt-to-income ratio, your liquid reserves, and the qualifications of your general contractor. Many lenders require that the GC be pre-approved or at least vetted before funding.

They will also review the plans and specifications and get their own appraisal of the completed home based on those plans. The loan amount will be limited to a percentage of that appraised value — typically 80–90% of the projected completion value. If your build costs exceed the appraised value, you will need to make up the difference in cash.

Down payments are typically 20–25% of total project cost (land + construction) for construction loans. Some programs — VA construction loans, USDA rural development loans, and a few specialty lenders — offer lower down payments, but these come with their own qualification requirements.

The construction loan does not give you all the money on day one. It works like a credit line: you draw funds as you need them to pay for completed work. The process typically works like this: you submit a draw request, the lender sends an inspector to verify that the work claimed is actually done, and then the lender releases the funds.

Draws are usually tied to specific milestones: foundation complete, framing complete, rough-in complete, drywall complete, finishes and substantial completion. A typical project has 4–6 draws. Each draw inspection costs $150–$300 and takes 2–5 business days to process, so factor that timing into your payment schedule with the contractor.

One common mistake: asking for draws before the work is complete. Inspectors are experienced and will flag incomplete work. A failed inspection delays the draw and delays payment to your contractor, which strains the relationship and can slow momentum.

During the construction period, you typically pay interest only on the outstanding balance — the amount you have actually drawn, not the total loan commitment. This keeps your monthly payments manageable while the house is being built.

The interest rate is usually variable, tied to prime rate, and runs 0.5–2% above your eventual fixed-rate mortgage. On a $400,000 loan drawn over 12 months, with an average outstanding balance of $200,000, at a 7.5% construction rate, you will pay approximately $15,000 in interest during construction. Budget for this in addition to any rent you are paying while displaced.

If you want to serve as your own general contractor, expect significantly more difficulty getting construction financing. Most conventional lenders will not make construction loans to owner-builders because the risk of an inexperienced manager causing cost overruns, scheduling disasters, or quality failures is higher.

Specialty lenders and some credit unions offer owner-builder loans, but they often require demonstrated construction experience, detailed project budgets, and larger reserves. The tradeoff — saving 15–25% of construction cost that would otherwise go to GC overhead and profit — is real, but the financing hurdle is significant. If this path interests you, research lenders before committing to the owner-builder approach.