When I first looked into building a house, I assumed financing would work like buying one. Apply for a mortgage, get approved, make payments. The reality of construction loans is entirely different, significantly more expensive, and full of traps for people who do not understand the draw schedule.
How construction loans differ
A traditional mortgage gives you a lump sum to buy an existing property. A construction loan disburses money in stages as the house is built. You only pay interest on the amount drawn so far, but the rate is typically 1-2% higher than a conventional mortgage, and the loan converts to a permanent mortgage (or requires refinancing) once construction is complete.
There are two main structures:
Construction-to-permanent loan: A single closing. The construction loan automatically converts to a permanent mortgage when building is complete. One set of closing costs. This is the simpler and usually cheaper option.
Stand-alone construction loan: Two separate closings -- one for the construction phase and one for the permanent mortgage. Double the closing costs but sometimes necessary if your permanent financing is not yet arranged or you want to shop for better permanent rates later.
The draw schedule
This is where construction loans get complex. The lender does not hand over $400,000 on day one. Instead, money is released in draws (also called disbursements) at predefined construction milestones:
- Land purchase/site prep: 10-15%
- Foundation: 10-15%
- Framing: 15-20%
- Rough mechanicals (plumbing, electrical, HVAC): 10-15%
- Exterior finishing (roofing, siding, windows): 10-15%
- Interior finishing (drywall, flooring, cabinets): 15-20%
- Final completion: 5-10%
Before each draw, the lender sends an inspector to verify the work is complete. If the inspector finds issues, the draw is held until they are resolved. This protects the lender but can create cash flow problems for the builder.
Interest during construction
During the construction phase (typically 12-18 months), you make interest-only payments on the amount drawn. This is where the cost calculation gets unintuitive.
On a $400,000 construction loan at 8.5%:
- Month 1 (10% drawn, $40,000): Interest = $283/month
- Month 4 (35% drawn, $140,000): Interest = $992/month
- Month 8 (65% drawn, $260,000): Interest = $1,842/month
- Month 12 (90% drawn, $360,000): Interest = $2,550/month
Total interest paid during 12-month construction: approximately $18,000-$22,000
This is money paid before you ever move in. It is not applied to principal. It is pure cost of construction financing.
The contingency buffer
Every construction budget should include a 10-20% contingency. Materials prices fluctuate, scope changes happen, and unforeseen site conditions (bad soil, rock, water table) add cost. If your construction budget is $350,000, plan for $385,000-$420,000 and structure your loan accordingly.
Running out of money mid-construction is catastrophic. The builder stops work, you are making interest payments on a half-built house, and getting additional financing for an incomplete structure is extremely difficult.
Rate lock considerations
Construction-to-permanent loans often offer a rate lock on the permanent mortgage at the time of closing. Given that construction takes 12-18 months, this lock protects you from rate increases during building. However, rate locks this long typically cost 0.5-1% of the loan amount.
If rates are at 7% when you close the construction loan and rise to 8% during the 14-month build, a rate lock saves you $400+ per month on the permanent mortgage. If rates drop, most lenders offer a float-down option for an additional fee.
Modeling the total cost
Between construction interest, closing costs, rate lock fees, inspection fees, contingency, and the permanent mortgage payments, the total cost of building and financing a home is complex. I built a construction loan calculator that models the full draw schedule, construction-phase interest, conversion to permanent financing, and total project cost.
I'm Michael Lip. I build free developer tools at zovo.one. 500+ tools, all private, all free.
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