Author credentials

I’m a CPA and CFP® with over 15 years advising homeowners, investors, and lenders on renovation financing. In practice I’ve arranged construction draws, negotiated interest caps, and helped clients convert short-term construction financing into permanent mortgages.

Why this matters

Renovation projects commonly run over schedule or budget. Choosing the right construction loan and managing draws and interest can reduce carrying costs, preserve cash flow, and protect home equity. Lenders use draws and inspections to control risk; borrowers who understand the mechanics borrow smarter.

How construction loans work (step-by-step)

  1. Application and approval: Lenders review credit, income, contractor bids, and an after-renovation valuation (ARV). Approval can be for a stand‑alone construction loan or a construction-to-permanent loan.
  2. Budget and draw schedule: Borrower and lender agree on a draw schedule that ties disbursements to milestones (demolition, framing, mechanicals, finishes). Lenders typically require detailed bids and may withhold a completion reserve (often 5–10%).
  3. Inspections and draws: A lender or third-party inspector verifies each milestone before releasing funds. Draws reduce the available loan balance and trigger interest on the withdrawn amount.
  4. Interest accrual: During the construction period interest is usually charged on the outstanding balance (only on funds disbursed). Many construction loans are interest-only during draws; interest may be variable and tied to an index or the lender’s rate.
  5. Conversion or payoff: At project completion the loan can be paid off, refinanced into a permanent mortgage, or automatically converted if it’s a one-time close construction-to-permanent loan.

(For more on conversion options, see our guide on converting a construction loan to a permanent mortgage.)

Interest: how it’s calculated and what to expect

  • Interest basis: Lenders typically charge interest only on the drawn amounts, not the total approved commitment. This lowers carrying costs compared with a fully disbursed loan.
  • Rate type: Most construction loans use variable interest rates tied to a short-term index (prime, SOFR, or the lender’s cost of funds) plus a margin. Some banks still offer fixed-rate options for the permanent phase.
  • Interest payments: During construction your payment may be interest-only; monthly payments cover only interest on the outstanding draws. After conversion, the loan amortizes according to the permanent mortgage terms.
  • Interest reserves: Lenders sometimes include an interest reserve within the loan to pay accrued interest during construction. An interest reserve reduces initial cash outflow but increases the principal to be repaid later.

Sources: Consumer Financial Protection Bureau (CFPB) explains construction loan basics and borrower protections, and FDIC materials summarize common mortgage structures (CFPB; FDIC). See also IRS guidance for tax treatment of mortgage interest or capital improvements (consult a tax advisor) (IRS).

Draw schedules and inspections — practical details

  • Typical draw frequency: Monthly or milestone-based (5–8 draws is common for major renovations). Simple projects may have 2–3 draws.
  • Inspection requirements: Lenders require evidence of completed work before releasing funds — invoices, photos, and on-site inspections. Expect holdbacks for subcontractor liens if the lender is protecting itself against incomplete work.
  • Holdbacks and retainage: Lenders may keep a 5–10% holdback until final closeout to ensure punch-list items are finished.

Example scenario
A homeowner secures a $150,000 construction loan for a full kitchen and two-bath remodel. The lender approves 6 draws tied to demolition, rough-in, drywall, finishes, appliances, and closeout. If the homeowner draws $60,000 in the first two months, interest accrues only on the $60,000 — not the full $150,000 — reducing cash costs during early phases.

Types of construction financing commonly used for renovations

  • One-time close (construction-to-permanent): Single closing that funds construction and automatically converts to a mortgage. Reduces closing costs and rate uncertainty.
  • Two-close or stand-alone construction loan: Short-term loan during construction; borrower refinances into a mortgage after completion.
  • Home equity options (HELOC or home equity loan): For smaller projects a HELOC can act like a draw facility with flexible access; compare interest and timing carefully. See our HELOC draw strategy guide for renovation planning.

Internal resources: See our pages on construction draw schedules and converting a construction loan to a permanent mortgage for more on timing and lender requirements.

Who is eligible and who should consider a construction loan

  • Homeowners with substantial renovations: If you’re changing structure, adding square footage, or doing an expensive systems upgrade, construction loans fit better than a personal loan.
  • Investors and flippers: Short-term financing that aligns with rehab timelines; lenders expect a solid exit plan.
  • Credit and equity: Lenders typically require stronger credit scores and a clear LTV calculation based on after‑renovation value. For major work expect requirements similar to purchase mortgages.

Costs beyond interest you should plan for

  • Origination and inspection fees
  • Appraisal (often an ARV appraisal)
  • Construction contingency reserve (recommended 10–20% of hard costs)
  • Closing costs for both construction and permanent loans if two closings are used
  • Possible impounds or interest reserves added to loan principal

Common mistakes and how to avoid them

  • Mistake: No contingency. Always build a 10–20% contingency for unexpected issues — older homes often reveal hidden problems.
  • Mistake: Unclear draw schedule. Negotiate a realistic draw schedule with your contractor and lender before closing.
  • Mistake: Hiring unlicensed contractors. Lenders usually require licensed, insured contractors — choose contractors who pass lender vetting.
  • Mistake: Ignoring timing on draws. Delays in inspections or permits can stall draws; make sure the timeline is realistic and permit-ready.

Professional tips and strategies

  • Lock or cap rates early for the permanent phase if market risk is a concern; pursue a one-time close construction-to-permanent loan when possible.
  • Use an interest reserve only when necessary; it adds to the loan balance and increases overall interest costs.
  • Get a detailed, line-item contractor estimate and a phased draw schedule tied to verifiable milestones.
  • Keep clear records: photos, receipts, and lien waivers help speed inspections and protect you from contractor disputes.

Frequently asked questions

Q: Will I pay interest on the full loan amount during construction?
A: No. Interest typically accrues only on amounts drawn. Some lenders offer an interest reserve that covers payments for a time, but that increases the loan principal.

Q: Can I convert a construction loan into a mortgage?
A: Yes. Options include a one-time close construction-to-permanent loan or refinancing a stand-alone construction loan into a traditional mortgage. Details and requirements vary by lender and loan product.

Q: Is construction loan interest tax-deductible?
A: Interest deductibility depends on how funds are secured and used. Interest on loans used to buy, build, or substantially improve a qualified residence may be deductible subject to IRS rules. Consult your tax advisor and see IRS guidance for 2025.

Real-world checklist before you apply

  • Obtain three contractor bids and a detailed scope of work
  • Confirm contractor licensing and insurance
  • Get an ARV appraisal and an itemized draw schedule
  • Budget a 10–20% contingency in addition to the loan amount
  • Ask the lender about inspections, holdbacks, and any interest reserve

Closing thoughts and disclaimer

Construction loans are powerful tools when used with realistic budgets, reputable contractors, and lender-savvy planning. In my practice, projects that follow a tight draw schedule with conservative contingencies are less likely to face cash-flow surprises.

This article is educational and not personalized financial or tax advice. For tailored guidance, consult a lender, CPA, or CFP® who can evaluate your project, tax situation, and financing options.

Authoritative sources

  • Consumer Financial Protection Bureau — Mortgages and construction financing: https://www.consumerfinance.gov (CFPB)
  • Federal Deposit Insurance Corporation — Consumer guides to mortgages and loans: https://www.fdic.gov (FDIC)
  • Internal Revenue Service — Mortgage interest and home improvements (consult a tax professional): https://www.irs.gov (IRS)