Construction Loan

A construction loan is a short-term loan (typically 12 months) that funds the building of a home. Unlike a regular mortgage, funds are not disbursed all at once — instead, the lender releases money in draws at predetermined construction milestones: land purchase, foundation, framing, roofing, rough-in (plumbing/electrical), drywall, and completion. At each draw, the lender typically inspects the work (or reviews photos) to verify progress. During construction, borrowers typically pay interest-only on the amount drawn. Rates are variable (prime + 1%–3%) and generally higher than permanent mortgage rates. At completion, the construction loan must be paid off — either by converting to a permanent mortgage or by obtaining a new purchase mortgage. See CFPB — Construction-to-permanent loans.

One-close (construction-to-permanent): a single loan closing covers both the construction phase and the permanent mortgage. After construction, the loan automatically converts to a permanent mortgage — no second closing, no second set of closing costs, rate may be locked at the original closing. Two-close: two separate closings — first for the construction loan, second for the permanent mortgage after completion. Benefits of two-close: flexibility to shop for the best permanent mortgage rate after construction; risk of two sets of closing costs and qualification at both closings. One-close is more popular for predictability; two-close is used when rates are expected to drop significantly before completion or when permanent financing is through a different lender. See construction loan to permanent mortgage 2027.

Construction loans are harder to qualify for than standard mortgages: (1) Credit score: typically 680+ for conventional construction loans; 660+ for FHA construction-to-permanent; (2) Down payment: typically 20%–25% for conventional; 3.5% for FHA one-time close; 0% for VA construction-to-permanent; (3) Detailed plans and specs: lenders require complete architectural plans, specifications, and a fixed-price contract from a licensed general contractor; (4) Builder approval: lenders must approve the general contractor — typically requires license, insurance, and experience; (5) Reserves: lenders often require 6–12 months of PITI in reserves; (6) Appraisal: a "future value" appraisal based on the completed plans. See how to buy land and build a house.

In Canada, construction financing works similarly but with key differences: (1) Draw structure: construction draws are common — typically 4–5 stages; CMHC and lenders inspect before each draw release; (2) New home purchase mortgage: if buying a newly built home from a developer (not self-building), standard CMHC-insured or conventional mortgages apply at purchase; (3) Self-build: for self-built or custom homes, construction mortgages are available through major banks and credit unions; (4) CMHC insured construction: CMHC-insured construction loans are available for multi-unit residential projects; (5) Tarion warranty: Ontario builders must be registered with Tarion — warranty coverage is considered by lenders. Major Canadian banks (TD, RBC, BMO) all offer construction mortgages. Rates are typically prime + 1.5%–3% during construction. See Canada new construction mortgage guide.

Construction cost overruns are common — industry data suggests 80%+ of projects exceed original budget. Protection strategies: (1) Fixed-price contract: require the general contractor to sign a fixed-price or guaranteed maximum price contract — cost overruns become the builder's responsibility; (2) Contingency budget: lenders often require a 10%–15% contingency reserve built into the loan; (3) Unused draw reserve: if draws are structured conservatively, remaining undisbursed funds provide buffer; (4) Interest reserve: some construction loans include an interest reserve to fund interest-only payments during construction. If genuine cost overruns exceed reserves: (a) borrower must fund the gap with personal cash; (b) lender may allow modification with additional collateral; (c) in worst cases, construction may stall and loan may default. See FHFA — Construction lending guidance.