What Is a Construction Loan? Financing a Home That Doesn't Exist Yet

A construction loan finances the building of a home rather than the purchase of an existing one. Because there's no finished property to serve as full collateral yet, lenders structure these loans very differently from a standard mortgage.

How Construction Loans Are Disbursed

Instead of one lump-sum payout, the lender releases funds in stages — called draws — tied to construction milestones (foundation, framing, roofing, finishing) and verified by inspections. You typically pay interest only on the amount drawn so far, not the full approved loan amount.

Construction-to-Permanent vs. Stand-Alone Construction Loans

• Construction-to-permanent: one loan and one closing that automatically converts to a standard mortgage once building is complete — the more common, simpler option
• Stand-alone construction loan: a separate short-term loan that must be paid off (usually by refinancing into a new mortgage) once the home is finished — two closings, two sets of closing costs

What Lenders Require

• Detailed construction plans, a signed contract with a licensed builder, and a realistic timeline
• Larger down payments than a typical mortgage — often 20-25% versus 3-20%
• Higher interest rates during the construction phase, reflecting the added risk of an unfinished asset
• A contingency reserve (often 5-10% of the budget) to cover cost overruns, which are common in new construction

Where Construction Loans Go Wrong

Cost overruns and delays are the two biggest risks — builders miss timelines, material costs shift, and change orders add up. Being under-budgeted on the contingency reserve is one of the most common reasons construction loans run into trouble before the home is even finished.