If you already own the lot, a construction loan when you own the land uses your equity in that parcel the way another borrower would use cash: it counts toward the down payment, and the lender advances the rest in stages as the house gets built. Depending on the product you choose, that financing either converts automatically into a permanent mortgage once the home is finished, or it gets paid off by a separate mortgage you close on later. The mechanics of how the lender values your lot, releases funds during construction, and handles the transition to a long-term loan are what determine your out-of-pocket cost and your risk.
Your Land Equity Is the Down Payment
Before approving the loan, the lender orders a professional appraisal of the lot to establish its current market value. If a land loan is still outstanding, the balance is subtracted from that appraised value. What’s left is your equity, and it functions exactly like a cash down payment.
The math is straightforward. A lot that appraises at $120,000 with $30,000 still owed gives you $90,000 in equity to bring to the deal. Conventional construction loans generally ask for 5 to 20 percent down, depending on credit and lender guidelines. FHA single-close construction loans can go as low as 3.5 percent, and VA construction loans may require nothing down for eligible veterans. When your land equity clears the required percentage on its own, you may owe nothing at closing.
There’s a ceiling on how far equity alone will take you. Federal banking regulators cap financing for one-to-four-family residential construction at 85 percent of the completed home’s projected value.1Federal Reserve. FAQs on the Calculation of Loan-to-Value Ratio Many lenders set their own limit at 80 percent, which is where the familiar 20-percent equity figure comes from. If your land equity doesn’t get you to the lender’s threshold, you’ll bring cash to make up the difference.
One Closing or Two
The choice between the two main loan structures affects how many times you close, when your interest rate gets set, and how much fee duplication you absorb.
Stand-Alone Construction Loans
A stand-alone loan, sometimes called construction-only, covers the building phase only. That phase typically runs 12 months or less. You make interest-only payments during construction, and when the house is done you either pay the loan off or apply for a separate mortgage (the industry term is a “take-out” loan) to replace it. You go through two full applications and two closings, pay two sets of lender fees, and carry the risk that a rate spike or a change in your finances makes the second loan harder to get.
Construction-to-Permanent Loans
A construction-to-permanent loan, also called single-close, wraps both phases into one transaction. You apply once, close once, and the construction financing converts automatically to a 15- or 30-year fixed-rate mortgage after the home is complete.2Fannie Mae. FAQs: Construction-to-Permanent Financing One closing means one set of title fees, appraisal charges, and origination costs. The rate is locked at closing, which shields you from rate increases across a long build. Some lenders offer a one-time float-down option that lets you drop your locked rate if market rates fall before the construction phase ends.
The USDA offers a single-close construction-to-permanent product through its guaranteed loan program. Borrowers pay interest only during construction, and the loan re-amortizes at a fixed rate for a 30-year term once the home is finished.3U.S. Department of Agriculture. Single Family Housing Guaranteed Loan Program Combination Construction to Permanent Loans
What Lenders Want to See
Construction loans are riskier than standard mortgages because the collateral doesn’t exist yet. That risk shows up in tighter qualifying standards, higher rates, and a thicker document file.
Credit, Income, and Rate
Most lenders want a credit score of at least 680 for a conventional construction loan, though some accept scores as low as 620 with compensating factors like a larger down payment or a lower debt-to-income ratio. You’ll document stable income with pay stubs, tax returns, and bank statements. Total monthly debt payments, including the projected mortgage, generally need to stay within 43 to 50 percent of your gross monthly income.
Rates on construction loans typically run one to several percentage points above standard mortgage rates. The exact spread depends on the program, your credit, and the lender. Closing costs generally land between 2 and 5 percent of the loan amount. Choose a stand-alone loan and you pay closing costs twice, which is a large part of why many borrowers prefer the single-close route.
Documents Tied to the Land
You’ll need a copy of the recorded deed from your county recorder’s office to prove you own the lot free and clear or to show the balance on any land loan still outstanding. The deed establishes the legal description of the parcel and confirms there are no undisclosed liens or title defects. Depending on location and lender, expect to add a survey, a soil or percolation test, or an environmental assessment. Fannie Mae guidelines require environmental hazard assessments when a Phase I screening flags potential contamination.4Fannie Mae. Environmental Hazard Assessments
Documents Tied to the Build
Blueprints and floor plans from a licensed architect show the lender what’s being built and drive the as-completed appraisal. Your general contractor provides a detailed line-item budget, often called a Schedule of Values, that breaks the total contract price into work phases such as foundation, framing, mechanical systems, and finishes. That budget accompanies a signed builder’s contract with the project timeline and either a fixed price or a cost-plus arrangement. The lender also needs the contractor’s general liability insurance certificate and, where required by state or local law, a current contractor’s license number.
The loan application itself is the Uniform Residential Loan Application, Fannie Mae Form 1003, which runs nine pages in its current version and captures the property address, estimated land value, total construction cost, and your income, assets, and debts.5Fannie Mae. Uniform Residential Loan Application (Form 1003) After everything is compiled, the lender performs a project review to confirm the budget aligns with regional market standards for comparable homes.
How the Money Reaches the Builder
You don’t get the full loan at closing. A construction loan releases funds in stages tied to building milestones through what’s called a draw schedule, and that staging protects both sides from paying for work that hasn’t been done.
A typical draw schedule divides the project into five to seven phases: site preparation, foundation, framing, mechanical rough-in, insulation and drywall, finishes, and final completion. When the contractor finishes a phase, they submit a draw request with invoices for the materials and labor used. The lender sends a third-party inspector to the site to verify the work matches the request before releasing funds. These inspections prevent overpayment for incomplete or substandard work.
Your monthly payments during construction are interest-only, and interest is calculated on the amount disbursed so far rather than the full approved loan. Early on, when only a fraction of the funds have been released, the payment is small. It grows with each draw.
Plan for Overruns
Construction projects routinely exceed initial budgets because of material price changes, weather delays, design modifications, or unforeseen site conditions. Lenders account for this by requiring a contingency reserve built into the loan, typically 5 to 10 percent of the total project budget. Some financial advisors recommend a larger cushion of 15 to 20 percent if your finances allow. Federal regulations for certain lenders specifically recognize a contingency account for unanticipated overruns as a qualifying cost in a construction budget.6eCFR. 12 CFR 723.6 – Construction and Development Loans If costs blow past the reserve, you’ll cover the gap out of pocket or negotiate scope reductions with your builder. Lenders will not raise the loan amount after closing because costs went up.
Protecting the Property During the Build
Builder’s Risk Insurance
Your standard homeowners insurance policy does not cover a house that’s being built, so lenders require a separate builder’s risk policy as a condition of closing. Builder’s risk covers theft of materials, fire, vandalism, weather damage, and damage to materials in transit or storage. The property owner usually buys the policy, though the general contractor may carry one as well. A standard policy term for new construction is 12 months, matching the typical construction loan duration. If a covered loss occurs during the build, the claim runs through the builder’s risk policy rather than any existing homeowners policy, so it won’t affect your homeowners rates or claims history. Once you move in, you cancel the builder’s risk policy and switch to standard homeowners coverage, which the lender will require before converting to a permanent mortgage.
Lien Waivers at Every Draw
If your general contractor fails to pay a subcontractor or materials supplier, that unpaid party can file a mechanic’s lien against your property even if you’ve paid the contractor in full. In the worst case, a lien holder can force a sale of the property to recover what’s owed.
The defense is a lien waiver at every draw. A lien waiver is a signed document in which the contractor, and ideally each subcontractor, confirms payment for the work in that phase and gives up the right to file a lien for that amount. Two versions exist:
- A conditional waiver takes effect only after the payment clears. Use this when issuing a check that hasn’t been cashed.
- An unconditional waiver takes effect immediately upon signing regardless of whether payment was received. Use this only after confirming funds landed.
Many lenders build waiver collection into the draw process and refuse to release the next round of funds until waivers from the prior draw are on file. If yours doesn’t, write the requirement into your builder’s contract. Collecting waivers at every stage is the single most effective way to keep a lien from surfacing after the project ends.
Finishing the House and Converting the Loan
The shift from construction financing to a long-term mortgage begins after your local building department issues a Certificate of Occupancy confirming the structure is safe to live in and meets code. The lender orders a final appraisal to confirm the completed home’s value supports the loan balance.
How the Conversion Runs
With a single-close loan, conversion is largely administrative. The lender modifies the loan, and your payments shift from interest-only on disbursed funds to fully amortized principal-and-interest payments on the total balance.3U.S. Department of Agriculture. Single Family Housing Guaranteed Loan Program Combination Construction to Permanent Loans With a stand-alone loan, you go through a second full closing, with a new application, new underwriting, and new closing costs, to get the permanent mortgage that pays off the construction debt.
At conversion, the lender typically opens an escrow account to collect monthly installments toward your property tax bill and homeowners insurance. Updated title insurance gets recorded to reflect the completed improvements and confirm the lender’s lien position.
PMI at the Finish Line
If the final loan-to-value ratio exceeds 80 percent, meaning you borrowed more than 80 percent of the completed appraised value, the lender will require private mortgage insurance. Fannie Mae guidelines require primary mortgage insurance on any conventional first mortgage with an LTV above 80 percent, calculated using the lower of the sales price or appraised value.7Fannie Mae. Provision of Mortgage Insurance PMI adds to the monthly payment but can be canceled once your equity reaches 20 percent. Because the completed home may appraise higher than expected, especially if market conditions improved during the build, the final LTV sometimes works in your favor.
Taxes and the Interest Deduction
Interest paid on a construction loan can be tax-deductible, but only under specific IRS rules. The IRS treats a home under construction as a qualified home for up to 24 months, provided it becomes your main or second home once it’s ready for occupancy. During that window, interest on the construction loan qualifies as deductible home acquisition debt, subject to the overall limit of $750,000 in mortgage debt, or $375,000 if married filing separately.8Internal Revenue Service. Publication 936 – Home Mortgage Interest Deduction If construction runs beyond 24 months, the interest paid during the excess period generally isn’t deductible as mortgage interest.
Expect a jump in your property tax bill too. Before construction, the lot was assessed as vacant land. Once the home is finished, and in some jurisdictions during construction, the assessor reassesses the property at its improved value. Many localities issue a supplemental tax bill for the increased assessment, and it can arrive months after you move in. Timing and amount vary by jurisdiction, so check with your local assessor’s office after your Certificate of Occupancy so a large bill doesn’t catch you off guard.