Building a new home or undertaking a major renovation requires specialized funding that differs from traditional mortgages. Construction phase financing is a short-term loan tailored to cover costs such as labor, materials, and land acquisition during the building process. Funds are dispersed in stages or “draws” tied to verified completion of specific milestones—this approach protects both borrower and lender by ensuring money is used appropriately.
How Does Construction Phase Financing Work?
Construction loans are structured around a draw schedule. At loan approval, you submit detailed plans, budgets, and timelines to the lender for review. Upon approval, the lender agrees to release funds in multiple draws corresponding to stages like site preparation, foundation, framing, roofing, and finishing.
Before each draw, an inspector or appraiser verifies the completed work. Only after approval does the lender release the funds to you or your builder. During construction, you generally make interest-only payments on the distributed amount, keeping payments lower until project completion.
Once the home is finished and passes final inspections, the construction loan converts into a traditional mortgage (known as a construction-to-permanent loan), or the borrower secures a separate mortgage to pay off the construction loan if using a standalone construction loan.
Types of Construction Loans
-
Construction-to-Permanent Loan (One-Time Close): A single loan process where construction financing transitions seamlessly into a permanent mortgage. This option consolidates closing costs and simplifies paperwork. Learn more about One-Time Close Construction Loans.
-
Standalone Construction Loan (Two-Time Close): Requires two separate closings—one for construction and another for permanent financing after completion. This allows borrowers to shop for better mortgage terms later but incurs extra costs.
Common Challenges and Tips
- Budgeting Carefully: Unexpected construction costs are common. A contingency reserve of 10-20% beyond your initial budget is recommended.
- Selecting a Reliable Builder: Your builder’s experience and financial stability are critical. Always verify references and credentials.
- Managing the Draw Schedule: Monitor construction progress to align with lender inspections and avoid payment delays.
Frequently Asked Questions
What down payment is required? Typically 20-25% of the total construction cost is needed upfront.
What if the project exceeds budget? Additional costs must usually be covered by the borrower; lenders rarely increase loan amounts mid-project.
Can I act as my own general contractor? Some lenders allow owner-builder loans but require proven experience, so this option is limited.
For detailed guidance, see related articles on Construction Loan Monitoring, Multi-Draw Construction Loans, and Owner-Builder Construction Loans.
