A complete guide to financing the construction of a new home, from lot purchase to permanent mortgage conversion.
NMHL Team2026-02-0514 min read
What Is a Construction Loan?
A construction loan is a short-term financing option designed to cover the costs of building a new home from the ground up. Unlike a traditional mortgage where you receive the full loan amount at closing, construction loans disburse funds in stages as building progresses. These stages, called draws, are released after an inspector verifies that specific milestones have been completed. Construction loans typically carry higher interest rates than conventional mortgages because they present more risk to the lender. The home does not yet exist as collateral, and there is always the possibility of cost overruns, delays, or the builder failing to complete the project. Most construction loans have terms of 12 to 18 months, after which the loan must either be paid off or converted into a permanent mortgage. During the construction phase, borrowers typically make interest-only payments on the amount that has been disbursed, not the full loan amount. This keeps payments manageable while your home is being built. Construction loans can finance everything from the land purchase and site preparation to materials, labor, and permits.
Construction loans typically require a down payment of 20-25% and carry interest rates 1-2% higher than standard mortgage rates due to the additional risk involved.
Key Tips
Get detailed construction estimates before applying for a loan
Include a contingency budget of 10-15% for unexpected costs
Choose a licensed and insured builder with a strong track record
Types of Construction Loans
There are several types of construction loans, each suited to different building scenarios. The construction-to-permanent loan, also known as a single-close loan, is the most popular option. It combines the construction financing and permanent mortgage into one loan with a single closing, saving you money on closing costs and simplifying the process. Once construction is complete, the loan automatically converts to a standard mortgage with a fixed or adjustable rate. The standalone construction loan, or two-close loan, keeps the construction and permanent financing separate. You close on the construction loan first, and once the home is finished, you apply for and close on a separate permanent mortgage. This gives you more flexibility in shopping for the best permanent mortgage terms, but you pay closing costs twice. Owner-builder construction loans are available for borrowers who plan to act as their own general contractor. These are harder to qualify for because lenders want assurance that the project will be completed professionally. Renovation construction loans, such as the FHA 203(k) or Fannie Mae HomeStyle, finance major renovations to existing properties and can be a good alternative if you are purchasing a fixer-upper rather than building new.
Key Tips
Single-close loans save money on closing costs and reduce paperwork
Two-close loans give you flexibility to shop for the best permanent rate
Ask about FHA and VA construction loan options for lower down payments
Qualification Requirements
Qualifying for a construction loan is more rigorous than qualifying for a standard mortgage. Lenders require a higher credit score, typically 680 or above, though some may accept scores as low as 620 for FHA construction loans. A larger down payment is also expected, usually 20 to 25 percent of the total project cost including land. Your debt-to-income ratio should generally be below 43 percent. Beyond your personal financial qualifications, lenders scrutinize the construction project itself. You must provide detailed building plans, specifications, a timeline, and a comprehensive budget. Your builder must be a licensed general contractor with adequate insurance, and the lender may require references and a review of the builder past projects. An appraisal of the proposed home based on the building plans is required to establish the future value of the property. Lenders want to ensure that the completed home will be worth more than the total construction costs. You will also need to secure all necessary building permits before closing on the loan. Some lenders require that you already own the land or include the land purchase in the construction loan.
Lenders evaluate both your financial qualifications and the viability of the construction project itself. Having an experienced, reputable builder significantly improves your approval chances.
Key Tips
Start gathering building plans and cost estimates early in the process
Verify your builder is licensed, insured, and has no pending complaints
Be prepared for a longer approval process compared to standard mortgages
The Draw Schedule Process
The draw schedule is one of the most distinctive aspects of a construction loan. Rather than receiving the full loan amount upfront, funds are released in a series of payments called draws that correspond to specific construction milestones. A typical draw schedule might include five to seven stages: land purchase and site preparation, foundation completion, framing, rough mechanical systems including plumbing, electrical, and HVAC, interior finishes, exterior finishes, and final completion. Before each draw is released, the lender sends an inspector to verify that the work has been completed according to plans and meets quality standards. The builder submits a draw request with documentation of work completed and invoices for materials and labor. The lender reviews the request, conducts the inspection, and releases the funds, usually within 5 to 10 business days. During construction, you make interest-only payments calculated on the cumulative amount disbursed. As each draw is released, your payment increases slightly. Understanding this process helps you manage cash flow and avoid construction delays caused by funding gaps.
Key Tips
Review the draw schedule carefully with your builder before construction begins
Keep detailed records of all work completed and materials purchased
Communicate regularly with your lender to ensure timely draw releases
Converting to a Permanent Mortgage
Once construction is complete, your construction loan must transition to permanent financing. With a construction-to-permanent loan, this conversion happens automatically. The construction loan balance becomes a standard mortgage, and you begin making regular principal and interest payments. You may have locked in your permanent rate at the time of the original closing, or you may have the option to lock at conversion, depending on your loan terms. With a standalone construction loan, the conversion requires a separate closing. You will need to apply for a permanent mortgage, go through underwriting again, and pay a second set of closing costs. However, this gives you the opportunity to shop for the best available rates and terms at that time. Before conversion, the lender will order a final appraisal to confirm the completed home meets the value projections used during approval. Any significant deviations from the original plans or budget overruns could affect your permanent financing terms. A certificate of occupancy from the local building authority is required before the loan can convert. Make sure all punch list items are completed and the property passes final inspections. Plan ahead for the transition to full mortgage payments, as the jump from interest-only construction payments to fully amortized mortgage payments can be substantial.
With a single-close construction loan, your permanent interest rate may be locked at the initial closing, protecting you from rate increases during the building period.
Key Tips
Confirm whether your permanent rate is locked or floating during construction
Budget for the increase from interest-only to full principal and interest payments
Ensure all construction is complete and inspected before requesting conversion
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Frequently Asked Questions
Most construction loans require a down payment of 20 to 25 percent of the total project cost, which includes the land, construction costs, and any contingency reserves. FHA construction loans may allow down payments as low as 3.5 percent, and VA construction loans offer zero down payment for eligible veterans, though these options have additional requirements.
Yes, if you already own the land, its value can often be used as part or all of your down payment for the construction loan. The lender will appraise the land at its current market value and credit that toward your equity position. This can significantly reduce the cash you need to bring to closing.
Cost overruns are one of the biggest risks in construction. If costs exceed your approved loan amount, you may need to cover the difference out of pocket, negotiate with your builder, or apply for a loan modification. Including a 10 to 15 percent contingency reserve in your original budget helps protect against this scenario.
Construction loans typically have terms of 12 to 18 months, though some lenders may extend up to 24 months for complex projects. If construction is not completed within the loan term, you may need to request an extension, which usually involves additional fees. Plan realistic timelines with your builder to avoid this situation.
Some lenders offer owner-builder construction loans, but they are harder to qualify for and may require higher down payments. You typically need to demonstrate relevant construction experience or professional qualifications. Most lenders prefer that a licensed general contractor manage the project to reduce risk.
