How Construction Loans Really Work

The Basic Structure

A construction loan is a short-term credit facility that funds the building of a new structure. Unlike a standard mortgage where all funds are disbursed at closing, construction loans release money in phases called draws. You receive funds as the project progresses, and interest is charged only on the amount drawn, not the full loan commitment.

The loan term is typically 12 to 18 months. When construction completes, the loan either converts to a permanent mortgage (in a construction-to-permanent product) or requires a separate refinance to long-term financing. The choice between these two paths has significant implications for cost, timeline, and closing complexity.

Draw Schedules and How They Work

The draw schedule divides the construction budget into milestone-based disbursements. A typical residential construction draw schedule has four to seven draws corresponding to phases like foundation, framing, rough mechanical work, drywall and insulation, finish work, and final completion. Each draw requires an inspection by a lender-approved inspector who verifies the work before funds are released.

The gap between completing a phase and receiving the next draw can be 3 to 10 business days, sometimes longer. Contractors and suppliers don't always wait for the next draw before expecting payment. Many borrowers are surprised to discover they need to carry some project expenses out of pocket and get reimbursed in the next draw. This is normal, but it needs to be part of the financial plan from the start.

The Interest-Only Phase

During construction, you pay interest only on the amounts drawn. If you've drawn $100,000 on a $500,000 construction loan at 8%, your monthly interest is roughly $667. As the project progresses and draws increase, monthly interest payments rise accordingly. The interest reserve, built into the loan at origination, covers these payments so you don't need to pay out of pocket during construction.

If the project runs over schedule and the interest reserve is exhausted, you'll need to start making interest payments from personal funds. That's one of the first places a construction project can create financial stress. Coventry Enterprises LLC reviews interest reserve adequacy in every construction loan we examine, because undersizing it is one of the most common errors in construction loan documents.

Converting to Permanent Financing

At the end of construction, the short-term construction loan needs to be replaced by long-term permanent financing. In a construction-to-permanent loan (also called a one-time close), this conversion is built into the original loan agreement. The construction loan automatically converts to a mortgage when construction completes and the certificate of occupancy is issued.

In a two-close arrangement, the construction loan is a standalone product and the permanent mortgage is a separate transaction requiring a new application, appraisal, and closing. Two-close structures cost more in total closing fees but may offer more flexibility in choosing the permanent loan terms.

Common Borrower Mistakes

The biggest mistake Coventry Enterprises LLC sees is inadequate contingency budgeting. Construction costs routinely run 10% to 20% over initial estimates. Materials cost more than expected, change orders happen, and weather delays add time. A budget with no contingency reserve has no margin for any of this.

The second most common problem is misunderstanding the draw timeline. Borrowers who assume they can fund contractor payments immediately from the construction loan run into trouble when they learn about inspection requirements and processing times. Planning for a 5 to 10 day gap between draw request and receipt is standard.

For a deeper dive into construction loan mechanics, including interest reserves and builder requirements, see our dedicated construction loan consulting page.