Construction loans finance building a home or commercial property from the ground up. They differ from standard mortgages in nearly every way — variable funding through draws, interest-only payments during the build, higher rates, and conversion to permanent financing at completion.
How Draws and Interest Reserves Work
Unlike a traditional mortgage where the full loan amount is funded at closing, construction loans release funds in stages called draws. Each draw corresponds to a construction milestone (foundation poured, framing complete, drywall installed, certificate of occupancy). The lender inspects the work before releasing each draw, ensuring the project is on schedule and on budget. Interest accrues only on the outstanding drawn balance, so early-build months have minimal interest cost. An interest reserve — funds set aside at closing — covers monthly interest payments during the build phase, eliminating out-of-pocket interest during construction. The reserve is calculated based on the average expected outstanding balance times the construction rate times the build duration, typically padded by 10–15%.
Construction-to-Permanent vs. Two-Close Loans
Construction-to-Permanent (C2P) loans combine the construction phase and permanent mortgage in a single closing. At construction completion, the loan automatically converts to a long-term mortgage at the pre-agreed permanent rate. The advantage: one set of closing costs (saves $4,000–$8,000), locked-in permanent rate from day one, and simpler approval process. Two-close construction loans separate the phases — you must qualify again for the permanent mortgage at construction completion. This re-qualification risk is significant if interest rates rise, income changes, or appraisals come in lower than expected. Two-close can win if rates fall significantly during construction (locking in lower at conversion), but the rate-risk and friction usually favor C2P for typical borrowers.
Budgeting Realistically — The 15–20% Contingency Rule
Construction costs almost always exceed initial estimates. Material price changes, weather delays, design revisions, and subcontractor availability all push costs up. Industry rule of thumb: budget 15–20% contingency over the contractor's hard-cost estimate, not 10%. Use the contingency for unexpected overruns only, not for upgrades or scope expansion. Once contingency is spent, additional cost overruns must be funded by borrower equity — lenders generally will not increase the loan mid-construction without significant re-underwriting. Cost-overrun budget exhaustion is the #1 cause of stalled construction projects. Build the contingency into the loan size before closing, then guard it ruthlessly during the build.
Common Pitfalls to Avoid
Several recurring mistakes turn manageable construction projects into financial disasters. First, hiring an unfamiliar or unproven builder solely on price. Construction-loan defaults are heavily concentrated among inexperienced or undercapitalized contractors. Verify the builder's track record, license status, insurance, and recent project references before signing. Second, skipping the lien waiver discipline at each draw. Without signed waivers from every subcontractor receiving payment, a mechanic's lien can be filed against the property even after you have paid the general contractor. Third, allowing scope changes without written change orders and budget adjustments. Verbal upgrades and design modifications during construction are the leading source of disputes and cost overruns. Fourth, failing to inspect work yourself before approving lender draws. The lender's inspector verifies progress but not quality — issues you spot before the next draw are far easier to fix than issues discovered post-occupancy.