Construction loans work by financing a home build in stages: the lender approves a total budget, releases money in scheduled draws as the builder completes each phase, and charges interest only on what has actually been disbursed. When the house is finished, the debt either converts automatically into a long-term mortgage or is paid off by a separate mortgage you close on at that point. Because the collateral doesn’t exist yet, underwriting is stricter, rates are higher, and the lender stays involved throughout construction in a way a standard purchase mortgage never requires.
Two Basic Structures
Almost every construction loan falls into one of two forms, and the choice shapes everything that follows.
A single-close loan, sometimes called construction-to-permanent, combines the building phase and the long-term mortgage into one set of documents. You close once, pay one set of closing costs (generally 2% to 5% of the total loan amount), and the loan shifts automatically into its permanent mortgage phase once the home is finished.1Fannie Mae. Conversion of Construction-to-Permanent Financing: Single-Closing Transactions The permanent terms, such as a 30-year fixed rate, are set before any ground is broken, and you can lock the permanent rate at that first closing so a rate spike during construction doesn’t hurt you.2Fannie Mae. Single-Closing Construction-to-Permanent Lender Fact Sheet
A stand-alone construction loan covers only the building phase, typically 6 to 18 months.3Fannie Mae. Two-Closing Construction to Permanent Financing Transaction Process When the home is complete, you apply for a new mortgage to pay off the construction debt. That second closing brings its own fees, a new appraisal, and fresh underwriting. The tradeoff: you get flexibility to shop the permanent rate after the house exists, but you carry the risk that rates or your finances have moved against you by then.
Government-backed one-time close programs exist through the FHA, VA, and USDA, each with their own eligibility and down-payment rules. If you qualify for one of those loan types for a regular purchase, ask whether the same lender offers the construction version.
Qualifying for the Loan
Construction underwriting looks at both you and the project. On the personal side, Fannie Mae’s automated underwriting system accepts debt-to-income ratios up to 50%, while manually underwritten loans cap at 36% to 45% depending on credit score and cash reserves.4Fannie Mae. Debt-to-Income Ratios Many lenders want to see a credit score of at least 680 before offering competitive rates, though Fannie’s floor is lower and FHA construction loans go down to 580 with a 3.5% down payment.
On the project side, you will need to submit a package that lets the lender price the finished home and confirm the plan is realistic:
- Architectural blueprints and floor plans, which the appraiser uses to estimate the completed home’s value and set the maximum loan amount.
- A detailed line-item budget (sometimes called a pro forma), listing every projected cost from foundation to fixtures. The lender checks each line against current material and labor prices.
- A construction timeline with start and end dates for each phase, showing the project fits inside the loan term.
- A signed construction contract with your builder, spelling out whether the price is fixed or cost-plus.
Lenders also underwrite the builder. Before approval, the lender will verify that your general contractor holds a valid license, carries general liability insurance, and has a track record of finished projects. Expect the lender to review a formal contractor qualification statement covering financial stability, past work, and references.
Most lenders also build a contingency reserve of 5% to 10% of the total project budget into the loan to absorb price spikes, unforeseen site conditions, or design changes. If your budget doesn’t already include a cushion, the lender will add one. Unused contingency stays undrawn and doesn’t accrue interest.
Down Payment and Land Equity
The minimum down payment depends on the program. Conventional single-close loans sold to Fannie Mae can go up to 95% loan-to-value on a primary residence, which puts the floor at 5% down.5Fannie Mae. Construction-to-Permanent Financing: Single-Closing In practice, many lenders set their own minimums at 10% to 20% because construction risk makes them more conservative than they’d be on a standard purchase. FHA construction loans require 3.5%, and VA loans require nothing down.
If you already own the lot, most lenders will count your equity in it toward the down payment. On a $400,000 project with an $80,000 lot you own outright, that land equity satisfies a 20% down-payment requirement. The lender orders an appraisal of the lot to confirm current value before applying the credit.
How the Money Reaches the Builder: Draws and Inspections
After closing, the lender does not hand over a lump sum. Instead, funds are released in stages, called draws, tied to specific construction milestones. Typical draw stages include site preparation, foundation, framing, roofing and exterior enclosure, mechanical systems (plumbing, electrical, HVAC), and final interior finish work.
To get each draw, the builder submits a request certifying that a phase is complete according to the original budget. The lender then sends a professional inspector to the site to confirm the work matches the plans and meets standard. If the inspector finds incomplete or substandard work, the lender withholds the draw until the builder corrects the issues. That way the money paid out always stays proportionate to the actual improvements on the property, which protects both sides.
Once the inspection passes, funds are usually wired to the builder within a few business days, and the cycle repeats until the home is finished. Many lenders also hold back a percentage of each draw, commonly 5% to 10%, until the entire project is complete. That holdback, called retainage, gives the builder an incentive to finish the punch list and leaves money in reserve to correct any defects found at the final walkthrough.
If actual costs exceed both the budget and the contingency reserve, the extra money comes out of your pocket. Fannie Mae does allow documented overruns to be financed into the permanent loan on two-closing transactions, but only if the overrun funds go directly to the builder at closing; reimbursing yourself later is treated as a cash-out refinance with tighter eligibility.6Fannie Mae. FAQs: Construction-to-Permanent Financing
What You Pay Each Month During Construction
While the home is being built, you make interest-only payments on the funds that have actually been disbursed, not on the full approved loan. If your loan is $400,000 but only $80,000 has been drawn for the foundation and framing, interest is calculated on that $80,000. Each new draw grows the outstanding balance, so the monthly payment climbs as the project advances. This structure keeps early payments manageable, which matters if you’re also paying rent or an existing mortgage while the new home goes up.
Construction-loan interest rates are almost always variable, typically set at a margin above the prime rate (for example, prime plus 1%). Because prime can move during construction, the monthly payment can shift even between draws. Interest-only payments continue until the project is complete and the loan either converts or is paid off.
Can You Be Your Own Builder?
Most lenders will not let you act as your own general contractor. Programs offering FHA and VA one-time close loans in particular prohibit self-builds, builds managed by a family member, and builds where your employer serves as the contractor. The rare lenders that do allow owner-builder loans generally require you to hold a contractor’s license and show past experience managing residential construction. Without that background, plan on hiring a licensed general contractor.
If Construction Runs Long
Construction projects often slip because of weather, material shortages, permit delays, or subcontractor availability. If the project isn’t finished before the loan term ends, you have to request an extension. Extensions are not guaranteed, and they usually come with added fees, extended interest-only payments, and sometimes a requirement to re-qualify based on your current financial picture.
If the builder abandons the project partway through, whether from financial trouble or a dispute, you remain responsible for the loan. The lender’s lien stays on the property, and you’ll need to hire a new contractor to finish or negotiate a resolution with the lender. That risk is why lenders vet builders so carefully up front and why builder’s risk insurance is standard through the construction period.
Finishing the Home and Converting the Loan
Once the builder is done and the local building department completes its final safety inspections, the loan reaches its endpoint.
On a single-close loan, the conversion is automatic. The lender confirms the final draw is paid, verifies the finished home, and the loan shifts into its amortizing phase where you start paying principal and interest on the full balance.1Fannie Mae. Conversion of Construction-to-Permanent Financing: Single-Closing Transactions The rate and term you agreed to at the original closing take effect. No new paperwork, no second round of fees.
On a stand-alone loan, you close on a brand-new mortgage to pay off the construction debt.3Fannie Mae. Two-Closing Construction to Permanent Financing Transaction Process This step requires a final appraisal of the finished home to confirm its value supports the permanent loan amount, plus a Certificate of Occupancy from the local building department certifying the structure is fit for habitation. Only after that certificate is issued can the permanent mortgage fund and the construction account close. You’ll pay a second set of closing costs and new title insurance, and rates may have moved in either direction since you started building.