Construction Loan

A construction loan is a short-term mortgage that finances the costs of building a house or major renovation. Unlike a traditional mortgage, which you draw once upfront, a construction loan advances money in periodic draws as the project progresses. When construction finishes, you convert the loan to a permanent mortgage or refinance.

The problem construction loans solve

A traditional mortgage is designed for an existing property: the lender appraises the house, the buyer puts down 10–20%, and the lender advances the full remaining amount on closing day. But a new house exists only on blueprints and a dirt lot. An appraisal is meaningless until the house is substantially complete. A builder cannot work if the lender holds all funds in escrow; the builder needs cash now to pay workers and suppliers.

A construction loan bridges this gap. The lender advances money in stages as the builder hits milestones—foundation poured, framing complete, roof on, utilities in, final inspection passed. Each draw is secured by a lien on the property and the land underneath. The builder uses each draw to pay subcontractors, suppliers, and labour. When the house is finished, the borrower secures a permanent mortgage (a takeout loan), which pays off the construction loan balance.

The draw process and inspection

Construction loans operate on a draw schedule: the borrower (or builder, if they’re the applicant) submits a request for funds when a phase of work is complete. The lender orders a construction inspector to verify that the work has been done to plan and quality standards before releasing the draw. For example, the first draw might be 20% of the total loan, released after the foundation and excavation are inspected. The second draw (15%) comes after framing; the third (15%) after roof and weatherisation, and so on.

The lender holds back a percentage of each draw—typically 10–20%—as a reserve. This holdback ensures the builder has incentive to finish on schedule and to code. If the project runs over budget, the builder must cover the excess from their own pocket or renegotiate the loan. If the borrower decides mid-project that they want to upgrade (larger garage, fancier fixtures), they must amend the construction budget and may need to inject more equity.

Interest-only versus full amortization

During the construction period, borrowers typically pay interest-only on the outstanding balance. If the lender has advanced $200,000 of a $500,000 loan, you pay interest on $200,000, not $500,000. As each draw is released, the interest accrues on the total. This keeps monthly payments low while the house is being built and no income is flowing from the property.

Some construction loans roll accrued interest into the principal balance, so nothing is paid until the permanent financing closes. Others require monthly interest payments out of pocket. Always clarify before signing—paying interest from your savings account drains cash while you’re also managing the construction timeline.

Once the house is finished and the permanent mortgage closes, interest-only ends and you begin amortizing the principal over 15 or 30 years, just like a traditional mortgage.

The permanent takeout mortgage

A construction loan cannot last forever. Lenders typically set a deadline of 12–24 months. Before you draw the final funds, you must have a takeout loan (permanent mortgage) approved and ready to close. This permanent mortgage pays off the construction loan when construction is complete and the lender has signed off on final inspection.

The permanent mortgage is underwritten before construction begins, not after. A lender will approve a takeout mortgage based on the completed appraisal, your credit, income, and assets—but that appraisal cannot happen until the house is nearly done. This creates a timing puzzle: you need takeout approval to draw the final construction advances, but the appraisal and full underwriting happen toward the end.

To solve this, many borrowers get a conditional takeout commitment: the lender agrees to refinance you once the house is done and passes final inspection, assuming your credit and employment haven’t changed. If your credit tanks or you lose your job mid-construction, the takeout may not close, and you’re left holding an expensive short-term loan with no way to convert it to permanent financing—a dangerous position.

Construction loans for renovation versus new build

A borrower renovating an existing house can sometimes use a construction loan, though options vary. Some lenders offer construction-to-permanent loans that begin as construction financing and convert to a home equity line (HELOC) or second mortgage after renovation is complete. Other borrowers use a HELOC or cash-out refinance to fund renovation upfront, avoiding the short-term construction loan timeline altogether.

New construction is the classic construction loan use case. A builder (if borrowing for development) or a homeowner building a custom home borrows the construction loan, draws as work progresses, and refinances into a permanent mortgage once the house is complete. The borrower lives in the finished house and makes normal amortized payments.

Costs and rates

Construction loans typically carry a higher interest rate than permanent mortgages—often 0.5–1.5% above the 30-year fixed-rate mortgage. This premium reflects the credit risk (construction projects can run over budget or stall) and the lender’s cost of monitoring draws and inspections.

Fees are often steeper too. Beyond the standard origination fee, expect:

• Underwriting and appraisal
• Construction inspection fees (one per draw)
• Title insurance and survey
• Processing and administration fees

All told, construction loan costs can run 2–3% of the loan amount, significantly more than a traditional mortgage. These costs are often rolled into the loan balance.

Who qualifies

Construction loan underwriting is strict. Lenders typically require:

• A 700+ credit score (higher than some conforming mortgages)
• A detailed construction budget and timeline
• A construction contract with a licensed builder
• Proof of land ownership (a clear title)
• A takeout mortgage commitment from another lender
• Proof of income and assets sufficient to cover shortfalls
• Sometimes a performance bond from the builder (guaranteeing the work will be completed)

If you’re a borrower without a builder (planning to hire one after closing), the lender wants detailed schematics and cost estimates before approving the construction loan. This adds weeks to the approval timeline.

The end state

When construction is done, the permanent mortgage closes and pays off the construction loan. Your loan balance now reflects the full construction cost (plus any overages and closing costs for the takeout). Your monthly payment jumps from interest-only to full amortization of principal plus interest over 15 or 30 years.

If the permanent mortgage rate has dropped, you come out ahead. If rates have risen and your takeout rate is higher than you expected, you may regret the lock. Some borrowers use an ARM for the construction period with a lower starting rate, accepting the risk that rates will reset after a few years.

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