How Does a Construction Loan Work?

A construction loan is designed for individuals and businesses that intend to build their own property instead of buying an established building. Unlike the traditional mortgage loan where the lender gets the home itself as collateral and a guarantee of not losing the money, a construction loan is much riskier.

First of all, due to an increased risk for the lender, construction loans are always offered with higher interest rate and more strict qualification criteria. Builders, who take out construction loans, are required to have up to 25% as a down payment. Later on, when the building is over and the house is ready for living, a borrower can transform the construction loan into a standard homeowner’s loan within the same lender.

In the process of a house’s building, the lender has right to visit and inspect building with the purpose to make sure everything goes on as planned. If the inspection reveals some flaws or schedule violation in the construction process, the terms of the loan can be changed in a negative way (higher interest rate, etc.).

Qualifying for a Construction Loan

A construction loan is a short-term loan, and therefore its terms are stricter and qualification criteria are tougher. The lender requires a builder (a borrower) to have considerable financial reserves in case he will need to cover unexpected expenses.

Construction Loan

Besides, a borrower must have an excellent credit score and an extensive credit history to get a construction loan on decent terms. If the borrower is a construction company, it has to provide the bank (or non-bank lender) with the detailed project of an upcoming building with the full scale calculations of each aspect.

The ceiling amount of a Construction loan depends on the estimated final property’s value after the construction is finished.

The key aspects of a Construction Loan

Very often, a construction loan is built on a “drawn down” principle, where the borrower doesn’t take all the money needed for financing the whole project, but he increases the borrowed amount gradually, covering expenses step-by-step as the process of construction develops.
It is important to know that lenders require builders to spend all money taken in the previous portion of the loan before getting another one.

Five Stages of Construction Loan’s payments

After the project of a future building is approved by the lender, a borrower has a right to receive the first installment of the Construction loan. There are five stages of a loan’s payment and each one happens after the preceding payment’s financial resources are fully exhausted.
There are two official types of Building Plans a borrower must follow after getting a Construction loan.

Construction Loan

Stage 1. This stage implies payment for making a building’s foundation and associated expenses. This is the stage where ground cutting and initial plumbing are done. This also includes all works for laying the floor, setting the underground electricity system (if there are floors with the heating system beneath), basement construction and all types of intra-basement works.

Stage 2.
 This stage includes all “frame” works for the future building. The lender is financing the roof and associated works, brickwork, outer and inner walls, windows, trusses, electricity system that lies inside walls and so on. This is the biggest part of construction works that wipes a second major part of the borrowed money (about 15%). The lender will require the builder to have some financial reserves to cover possible unforeseen expenses.

future building

Depending on the lender this stage can be divided into two sub-stages.

Stage 3. During this stage of building process, the lender provides funds for the rest of all inner walls and outer façade works that will allow the house to be locked. That is why this stage is called a “Lockup” one.

This is the most expensive stage of construction and it typically “eats out” about 35%-40% of the whole loan’s amount. After this stage is complete, the home becomes practically livable and it can be considered as an established property with the market value. This is where lender’s risks start decreasing.


Stage 4. The stage is called “fit out” or “second fixing”, during which all fixing and fitting works are done. On this stage, where the house is almost ready, many lenders allow turning the Construction loan into the where the home acts as collateral and the interest rate is reconsidering. A borrower gets bore beneficial terms and lower interest rate to pay. Also, the time period of the loan can be extended.

Stage 5. This is the completion stage which requires a minimum financial for final works. That may include walls painting, lights installation, cleaning of the inner and outer space of the building, making all decoration elements perfectly fitted.

The Bottom Line

construction loan

A construction loan can be a great and beneficial option for those who do not want to buy an established property. Comparing to the homeowner’s loan (a Mortgage), Construction loan can be way cheaper, even in spite of a slightly higher interest rate. Because the payments are done in five steps, the interest rate is paid only for the certain part of the loan and not for the whole borrowed amount.