Construction Loans, Explained Like You Have a Day Job

Most clients have financed a house before. They've never financed building a house. The two are different products with different rules, different math, and different vocabulary. Here's the plain-English version.

Construction loans vs. mortgages

A regular mortgage funds the purchase of an existing house, you make principal-and-interest payments from day one, term is 15 or 30 years.

A construction loan funds the building of a new house. You don't make principal payments during construction — only interest, and only on the portion of the loan that's been drawn so far. The loan typically lasts 12–24 months, then converts to a regular mortgage when the house is finished.

Construction-to-permanent (the one you usually want)

Most luxury custom-home clients use a "construction-to-permanent" loan, or C2P. One application, one closing, one set of fees. The loan funds construction, then automatically converts to a 15- or 30-year mortgage when the house gets its certificate of occupancy.

The alternative is a two-time-close construction loan: separate construction loan, separate permanent mortgage, two sets of closing costs. Rarely worth it unless you have a specific reason.

Draws — how money actually moves

You don't get the full loan amount at closing. The bank releases funds in stages called draws, tied to construction milestones. Typical draw schedule for new construction:

1. Foundation complete (~10% of loan)
2. Framing & sheathing (~15%)
3. Dry-in: roof, windows, exterior doors (~15%)
4. Mechanical rough-ins (~15%)
5. Insulation & drywall (~10%)
6. Interior finishes (~15%)
7. Final trim, fixtures, landscape (~15%)
8. Final inspection & certificate of occupancy (~5%)

Before each draw, the bank sends an inspector to verify the work is complete. The builder gets paid, the loan balance grows, you start paying interest on the new amount.

The draw schedule is the heartbeat of your project. Get it right and the math is calm. Get it wrong and the builder is fronting their own money waiting for the bank.

Interest reserve — the line item that confuses everyone

During construction you're paying interest on the loan, even though no one is living in the house. Most banks roll those interest payments into the loan itself — you don't write checks each month, the bank just adds the interest to your balance. That's the interest reserve.

For a $2M loan at 7.5% over an 18-month build, your total interest cost is roughly $112K–$140K, depending on the draw schedule. That's money you need to either pay out of pocket or have built into your loan amount.

Conversion — what changes when the house is done

On the day the house gets its certificate of occupancy, your construction loan converts to a permanent mortgage. The interest rate may reset to current rates (depends on your loan), the term resets to 15 or 30 years, and you start making P&I payments like a normal mortgage.

Modern C2P loans usually lock the permanent rate at closing — meaning you know your post-construction payment up front. Older floating-rate construction loans can leave you exposed to rate increases during the build. Ask your lender explicitly which one yours is.

What lenders care about

A construction loan underwrite looks at three things:

1. You — income, credit, assets, liquidity (often 20–30% liquid reserves required beyond the down payment)
2. The builder — license, insurance, bonding, references, completed projects
3. The project — appraised future value of the finished home vs. your loan amount (loan-to-future-value ratio)

If any of the three is weak, the loan stalls. The strongest application has a builder the bank already knows, a project that appraises well above the loan, and a borrower with reserves to cover overruns. Find a builder your bank has worked with — the process moves twice as fast.

Five questions to ask your lender on the first call

1. Is your construction loan one-time close (C2P) or two-time?
2. Is the permanent rate locked at closing, or set at conversion?
3. What does your draw schedule look like and who inspects?
4. How is the interest reserve calculated, and is it inside or outside the loan amount?
5. What is the contingency reserve requirement and how do I access it during the build?

Five questions. The lender's answers tell you everything about the experience you're about to have.

— Margaret Larsen, COO. Eighteen years guiding clients from first conversation through groundbreaking — budgets, contracts, permits, financing. Get the free Ultimate Home Building Checklist for the field-tested list we walk every Angel home through.