Construction Loan
Short-term financing that pays for a building while it is being built.
Quick Answer
A construction loan is short-term financing that funds the cost of building a project, released in stages called draws as work is completed and inspected. Borrowers usually pay interest only on the amount drawn. The loan is repaid when the project is finished, typically by refinancing into a permanent loan or by selling the property.
The Full Picture
A construction loan exists because a building has no value as collateral until it is built. Lenders therefore fund the work gradually and tie each release of money to verified progress, which limits their exposure if a project stalls. This makes the loan fundamentally different from a mortgage on a finished building.
Mechanically, the lender approves a total commitment based on the budget, plans, contracts, the borrower's equity, and the projected value of the finished project. The borrower then submits draw requests, usually monthly, supported by pay applications, lien waivers, and often a lender's inspector's confirmation of percent complete. Many lenders hold back retainage and require the borrower's equity to go in first.
Interest during construction accrues only on the balance drawn, and many loans include an interest reserve funded from the loan itself so the borrower does not need to make payments out of pocket. Terms are commonly measured in months to a few years, and extension options are often tied to completion milestones. Loan-to-cost and loan-to-value limits vary widely by lender, property type, and market, so figures should always come from the term sheet.
For a contractor, the loan matters because it governs cash flow. A reliable budget, a credible schedule, and a defensible guaranteed maximum price are what lenders underwrite. Late or disputed draws can delay payment to subcontractors, so contractors on financed jobs pay close attention to how the lender's draw process interacts with their own billing.
Real Examples
Common Misconceptions
People assume: A construction loan pays out the full amount at closing.
Actually: Funds are released in draws as verified work is completed. The borrower typically pays interest only on the drawn balance, not on the full commitment.
People assume: A construction loan is the same as a mortgage.
Actually: It is short-term, interest-only, draw-based, and secured by a project that does not yet exist as a finished asset. It is generally repaid or refinanced at completion rather than amortized over decades.
Frequently Asked Questions
How does a construction loan draw work?
The borrower submits a draw request, usually monthly, with the contractor's pay application and lien waivers. The lender, often with an inspector, verifies the work in place and releases the corresponding funds, sometimes less retainage.
Do you pay interest on the whole construction loan?
Typically no. Interest accrues on the amount drawn to date, so the interest cost rises as more of the loan is used. Many loans fund interest from an interest reserve.
What happens when construction is finished?
The construction loan matures and is repaid, usually by refinancing into a permanent loan, by a construction-to-permanent conversion, or from sale proceeds.
What do lenders look at before approving one?
Commonly the budget, plans and permits, the contractor's qualifications and contract, the borrower's equity and experience, the appraised or projected value, and the plan for takeout. Specific requirements differ by lender.
Why does the contractor care about the borrower's loan?
Because the draw process controls when the contractor is paid. Understanding lender requirements for lien waivers, retainage, and inspections helps avoid payment delays.