A Construction Loan Is Not a Mortgage

It is a commitment to lend, not a sum of money

The mental model that causes trouble is the mortgage one: a lump arrives, you own it, you pay for it. A construction loan is a facility. The lender agrees a maximum, agrees a schedule of stages at which money will be released, and then releases nothing until each stage has been reached and verified — usually by an inspector who visits the site and confirms that the work billed has actually been done. Money you have not drawn is money you are not paying for, which is why the schedule of stages is the single most important document in the file after the budget itself.

Two further differences follow from that structure. The first is that during the build you usually pay interest only — there is no principal to amortise, because the balance is still growing. The second is that the loan has a hard end date, typically twelve to eighteen months, and it is not a maturity in the mortgage sense but a deadline: at that point the facility must either convert to long-term financing or be repaid. A construction loan that reaches its end date with the building unfinished is a serious problem, and it is the scenario every clause in the agreement is written to anticipate.

Interest on what is drawn, and why it is roughly half

Work the schedule in the table month by month. In month one the balance is $40,000 and the interest is $40,000 × 0.085 ÷ 12 = $283.33. Month two draws nothing, so the balance and the interest repeat. Month three draws $70,000, taking the balance to $110,000 and the monthly interest to $779.17. And so on: $1,204.17 a month from month five, $1,770.83 from month seven, $2,266.67 from month nine, $2,620.83 in month eleven and $2,833.33 in the final month when the whole $400,000 is outstanding. Add the twelve figures and the interest during construction is $18,062.50.

There is a shortcut that explains the result and travels to any schedule. Add the twelve monthly balances and divide by twelve: the average outstanding balance across the build is $212,500, which is 53.13 percent of the facility. Interest on an average balance for a year is just that balance times the rate, and 53.13 percent of $34,000 is $18,062.50 — the same answer. So the whole question reduces to one number: what fraction of the facility is outstanding on average? Draw early and heavily and that fraction rises toward one; draw late and the cost collapses. A schedule that front-loads a large payment for materials is not free, and the interest consequence of moving that payment three months later is computable before you agree to it.

Converting to permanent financing: one closing or two

When the building is finished, the short expensive facility has to become a long ordinary loan, and there are two ways to arrange it. A single-closing structure — construction-to-permanent — sets both up in one transaction at the start: you sign once, the loan draws down during the build, and it converts automatically to amortising terms on completion. A two-closing structure treats them as separate deals: the construction loan is arranged first, and a distinct mortgage is arranged later to repay it. The trade-off is straightforward. One closing costs one set of fees; two closings cost two. On our $400,000 project a second set of closing costs at 1.5 percent is $6,000 of pure duplication.

The countervailing argument is rate risk, and it runs the other way. Signing once fixes the terms of the permanent loan at the start of a build that will last a year or more, which protects you if rates rise and traps you if they fall. Two closings leave the long-term rate open until the building exists, which is an advantage in a falling market and an exposure in a rising one — and, more seriously, it leaves the refinancing itself conditional on your circumstances at that later date. A job change, a drop in income or a valuation that comes in below the budget can all prevent the second loan from being written, and the construction facility falls due regardless. Single closing costs less and removes that risk; two closings cost more and keep an option. On our figures the permanent loan at 6.5 percent over thirty years pays $2,528.27 a month either way.

Contingency and retainage do different jobs

Two sums are held back in every well-drawn construction deal and they are constantly confused. The contingency reserve is yours: an allowance, commonly around 10 percent of the build cost — $40,000 on our $400,000 project — set aside for the things nobody drew. Rock where the drawings assumed soil, a service diverted, a material substituted because the specified one is unavailable. It is not fat in the budget; it is the budget acknowledging that a building is discovered as much as it is designed. A project financed with no contingency is a project whose first surprise becomes a funding crisis.

Retainage is the builder's money and it is held from them, not from you. A percentage of each certified payment — commonly around 10 percent, so $7,000 held from a $70,000 stage payment — is withheld and released only when the work is complete and any defects made good. Its purpose is leverage: it ensures the contractor has an unpaid balance worth returning for at the point where the remaining work is small, tedious and unprofitable, which is precisely the point at which builders otherwise disappear onto the next job. The two reserves therefore protect against opposite failures. Contingency protects you against the building costing more than expected; retainage protects you against the building not being finished.

Why the rate is high: an unfinished building is poor collateral

Lending is priced on what the lender can recover if the borrower stops paying, and that is the whole explanation for the rate on a construction loan. A finished house has a market. A half-built house has almost none: the pool of buyers is limited to people willing to take on someone else's partly executed design, with unknown workmanship behind closed walls, an unpaid contractor who may have registered a claim against the title, and a set of permissions that may lapse. Recovery in that scenario is slow, uncertain and expensive, so the loan is priced above a mortgage on the same property once complete.

Everything else that makes these loans irritating follows from the same fact. The inspections exist because the lender is advancing money against work it cannot otherwise verify. The retainage exists because the last ten percent of a build is the part most likely never to happen. The short term exists because the lender wants the risky phase over quickly. The personal guarantee that lenders frequently require exists because the collateral alone is not good enough during the build. None of it is arbitrary, and understanding the reason makes it much easier to negotiate the parts that are genuinely negotiable — the draw schedule, the inspection cadence and the definition of each stage — rather than the parts that are not.

In France the staged schedule is not negotiated, it is statutory

Where a French buyer purchases a home yet to be built, the transaction is usually a vente en l'état futur d'achèvement, and the payment schedule is fixed by regulation rather than by the developer. Article R261-14 of the construction and housing code caps the cumulative amount payable at 35 percent of the price on completion of the foundations, 70 percent when the building is weathertight, and 95 percent on completion of the works, with the balance due on delivery — and that last 5 percent may be placed in escrow where the buyer disputes conformity with the contract. On a 400,000 project those ceilings are 140,000, 280,000, 380,000 and a final 20,000.

The contrast with the American structure is instructive because it relocates the risk rather than removing it. Under the staged statutory schedule the buyer's exposure is bounded by law at every point of the build: the developer can never hold more of your money than the works justify, and the completion guarantee that accompanies the sale exists to finish the building if the developer fails. Under a construction loan the borrower carries the completion risk directly and the lender manages it through inspections and retainage. Neither approach is free. The buyer in a staged sale gives up control over the design and the contractor; the borrower with a construction loan keeps that control and takes the risk that comes with it.

Frequently asked questions

Do I make principal payments during the build?

Normally no. The usual structure is interest-only during construction, calculated each month on the balance drawn so far, with the principal repaid in full on conversion to the permanent loan or on sale. That has an obvious cash-flow implication and a less obvious budgeting one: the interest payment grows every time a draw is made, so the monthly cost in the final months of the build is many times what it was at the start. On our schedule the first month's interest is $283.33 and the last month's is $2,833.33 — ten times as much. A household that is also paying rent or an existing mortgage during the build needs to plan for the later figure, not the earlier one.

What happens if the build runs past the end date?

It becomes an extension negotiation, and the terms of it are worth reading before you need them rather than after. A construction facility has a hard maturity, and if the building is not finished and the permanent loan cannot be written, the lender is entitled to be repaid on a building that is by definition unsellable. In practice most lenders will extend, and most extension clauses carry a fee and often a higher rate for the extended period. What varies enormously is whether the extension is at the lender's discretion or available as of right on stated conditions. That distinction is worth more than a small difference in the headline rate, because a discretionary extension negotiated from a position of weakness is expensive in a way no rate sheet shows. Ask what triggers an extension, what it costs and who decides, and get the answer in the agreement.

Can land I already own count as the deposit?

Frequently yes, and it is one of the most useful features of this kind of lending. Where the borrower already owns the plot outright, its appraised value is commonly treated as equity in the project, which can reduce or eliminate the cash deposit required. The amount credited is the plot's value as assessed by the lender's valuer and not what you paid for it, so a plot bought cheaply years ago may contribute considerably more than its purchase price, and one bought recently at a keen price may contribute less than you expect. Where the plot is still mortgaged — under a land loan, for instance — the construction facility usually has to repay that loan as part of the first draw, which reduces the equity credit accordingly and needs to be in the cash-flow plan from the start.

Is a single closing always cheaper than two?

Cheaper in fees, not necessarily cheaper overall, and the gap between those two statements is where the decision lives. A single closing avoids a second set of costs — $6,000 on our project at 1.5 percent — and removes the risk that the permanent loan cannot be arranged when the time comes, which is the more serious of the two considerations. What it costs you is the rate: you are fixing the terms of a thirty-year loan at the start of a build, and if long rates fall meaningfully over that year you will be holding a loan priced for a world that no longer exists, with a refinance and its own costs as the only remedy. Compare the two properly by pricing the second closing against the rate difference you would expect, and be honest that you are pricing an option on interest rates rather than choosing between two administrative arrangements.

Why do lenders inspect before every draw?

Because the only thing standing behind the money already advanced is work that exists, and the lender has no other way to know that it does. An invoice proves that a contractor asked to be paid; it does not prove that the foundations were poured. The inspection converts a claim into a verified fact before more money moves, which protects the lender and, less obviously, protects you: an independent professional confirming that each stage is genuinely complete before the corresponding payment is released is exactly the control a homeowner would want and would rarely commission on their own. The practical advice is therefore not to resent the inspections but to align them with your own interests — ask for a copy of every inspection report, and treat any discrepancy between what was certified and what you can see as something to raise immediately rather than at the end.