Overview
Construction loans are specialized short-term financing designed to pay for the costs of building a new home or completing a major renovation. Unlike a standard mortgage that funds a finished property in a single lump sum, construction loans pay out in phases—called draws—tied to specific milestones. Lender inspections verify progress before each draw, and interest is typically charged only on the amount disbursed. In my 15 years helping clients finance construction, projects that set a clear draw schedule and anticipate inspection requirements finish on time and with fewer surprise costs.
(Authoritative sources: Consumer Financial Protection Bureau and HUD provide plain-language guides to construction and construction-to-permanent financing—see CFPB and HUD.)
How draw schedules work and why they matter
A draw schedule breaks the total project budget into staged disbursements that match construction milestones (for example: foundation, framing, roofing, mechanicals, and finish). Each draw typically requires:
- A formal request from the borrower or contractor.
- Evidence of completed work (invoices, lien waivers, photos).
- A lender inspection or certified third‑party inspector.
- Any required municipality inspection sign-offs.
Why this matters: draws control lender risk and prevent borrowers from paying interest on money not yet used. They also protect you and the lender from fraud or incomplete work.
Practical note: Aim for a conservative draw schedule that matches realistic construction timelines. If you front-load draws, you risk running short later; if you under-budget early, the builder may stall waiting for funds.
Internal resources: For a deeper look at disbursements and timing, see FinHelp’s guide on Construction Loans and Draw Schedules: How Disbursements Work.
Inspections: types, timing, and common stumbling blocks
Inspections are the gatekeepers of the draw process. There are three common types:
- Lender or third-party progress inspections: Confirm the work billed for the current draw was completed to contract standards.
- Municipal or code inspections: Required sign-offs (electrical, plumbing, structural) that show compliance with local building codes.
- Final/occupancy inspections: Required to obtain a certificate of occupancy and to move from construction financing into permanent financing.
Common stumbling blocks:
- Missing documentation (invoices, lien releases, or permits) delays disbursement.
- Code violations discovered at inspection halt draws until corrected.
- Scheduling mismatches—municipal inspectors can have limited availability.
Best practices:
- Coordinate municipal inspections early and book them well in advance.
- Keep organized packets for each draw request (photos, receipts, lien waivers).
- Confirm the lender’s inspection requirements and whether they accept certified third‑party inspectors.
Interest handling during construction
How interest is charged
- Interest is normally charged only on the amount that has been disbursed (the outstanding draw balance), not on the total loan commitment.
- Most construction loans are interest-only during the build phase. Borrowers typically pay monthly interest on the drawn balance.
- Interest rate structure: construction loans often have higher rates than permanent mortgages because of higher risk and shorter terms.
Payment methods
- Direct monthly interest payments: The borrower pays interest monthly during construction.
- Roll into permanent loan: With a construction-to-permanent loan (one-time close), interest accrued during construction can be rolled into the permanent mortgage balance at conversion.
- Escrowed interest: Some lenders add interest to the loan and collect payments at conversion.
Practical advice
- Ask the lender whether interest payments are due monthly or will be capitalized at closing; misunderstanding this creates cash-flow surprises.
- Budget interest as a separate line item in your cost breakdown so you have liquidity during construction.
For mechanics of converting construction interest into a permanent mortgage, see FinHelp’s Construction-to-Permanent Mortgages: Process and Draw Schedules.
Holdbacks, retainage, and contingency reserves
Lenders commonly require a retainage or holdback—an amount (often a percentage of the last draw) withheld until final completion and closing. The holdback protects against punch-list items or contractor defaults. Typical protections include:
- A final 5–15% retainage on the contract or final draw.
- A contingency reserve (often 5–10% of total hard costs) to cover unforeseen overruns.
- Proof of paid subcontractors and lien waivers to avoid mechanics’ liens at close.
Plan for these, because having a large final holdback without a reserve can create a funding gap at project closeout.
Eligibility, underwriting, and documentation
Lenders underwrite construction loans differently than standard mortgages. Key factors include:
- Credit and liquidity: Good credit and cash reserves reassure lenders; expect to document liquid assets for overages.
- Builder credentials: Lenders prefer experienced, licensed builders with verifiable references and financial stability.
- Detailed budget and timeline: A thorough cost breakdown (hard costs, soft costs, contingency, permits) is essential.
- Plans and permits: Approved plans, construction contracts, and required local permits are usually required before closing.
Common lender conditions:
- Verification of builder insurance and performance bonds when applicable.
- Appraisal of the completed value using plans and specs (the lender wants to know the future value once finished).
Strategies to reduce delays and borrowing costs
- Build a conservative contingency: Keep 5–10% of hard costs in reserve for surprises.
- Tight documentation process: Create a draw packet template with required documents to avoid last-minute scrambling.
- Pre-schedule inspections: Book municipal and lender inspections early and confirm availability.
- Work with a lender with construction experience: An experienced construction underwriter anticipates common snags.
- Consider a construction-to-permanent loan if you prefer one closing and lower total closing costs—but verify conversion terms and any rate locks.
In practice: I’ve seen projects where a well-organized draw packet and pre-booked inspections reduced funding turnaround from two weeks to 48–72 hours—saving both time and interest expense.
Typical pitfalls and how to avoid them
- Underestimating total project cost: Use line-item estimates and include soft costs (permits, fees, utility hookups).
- Missing lien waivers or final contractor releases: Request these at each draw and before final disbursement.
- Ignoring local code timing: Municipality inspections often control the critical path—coordinate them deliberately.
Closing the construction loan
Closeout requires:
- Final inspection and certificate of occupancy.
- Final lien waivers and proof all subcontractors paid.
- Conversion to permanent financing or payoff of the construction balance.
See our guide on Construction Loan Closeout for a checklist of closeout documents and common lender requirements.
Real-world example (condensed)
A homeowner building a 2,500 sq. ft. custom home set a six-draw schedule and built a draw packet template that included photos, invoices, lien waivers, and municipal sign-offs. By pre-booking municipal inspections and using a local third-party inspector approved by the lender, they reduced the average draw turnaround to 3 business days. Shorter turnarounds cut interest costs and kept the contractor on schedule.
Sources and further reading
- Consumer Financial Protection Bureau (CFPB) — consumerfinance.gov: general information on construction loans and mortgages.
- U.S. Department of Housing and Urban Development (HUD) — hud.gov: FHA construction programs and guidance.
- FinHelp internal guides linked above on draw schedules, construction-to-permanent loans, and closeout procedures.
Professional disclaimer
This article is educational and does not constitute financial, legal, or tax advice. Lending rules vary by lender and state, and construction and permitting requirements vary by municipality. Consult your lender, attorney, or financial advisor for guidance specific to your project.
