Construction Loan
Short-term financing for building real estate that converts to a permanent mortgage after project completion.
What is Construction Loan?
A construction loan is a short-term, typically variable-rate loan that finances the cost of building a new home or commercial property from the ground up. Unlike a traditional mortgage, funds are not disbursed in a lump sum; instead, the lender releases the money in a series of draws as construction milestones are verified by a third-party inspector. The borrower pays interest only on the funds drawn, keeping carrying costs manageable during the build phase. Once construction is complete, the loan typically converts to a standard permanent mortgage (in a construction-to-permanent structure) or must be repaid through a separately arranged mortgage. Higher interest rates and stricter qualification requirements—including detailed construction plans, builder contracts, and cost estimates—reflect the elevated risk lenders face before a completed, habitable property exists as collateral.
Example
A developer borrows $900,000 through a 12-month construction loan at prime plus 1% to build a custom home. The lender releases funds in four draws: foundation ($200,000), framing ($250,000), rough-in mechanicals ($250,000), and final completion ($200,000). After the certificate of occupancy is issued, the loan converts to a 30-year fixed mortgage at a lower permanent rate.
Source: Investopedia — Construction Loan