Construction Loan

A construction loan pays for building a new project, or a major rebuild, over time. The lender commits to a total amount but releases it in stages as work gets done. Each release is a construction draw. Interest is charged only on money that has gone out, so the balance and the interest bill grow as the building rises. When the project is finished, the loan is paid off from a sale or from a permanent "takeout" loan.

Lenders size construction loans against both cost and value. Loan-to-cost (LTC) compares the loan with the total budget. Loan-to-value compares it with the expected finished value. Here is an example with round, hypothetical numbers: a project costs $1,000,000 to build and should be worth $1,300,000 when done. At 80 percent LTC, the lender commits $800,000, and the borrower puts in the other $200,000, usually before the first draw.

A construction loan carries parts that a regular loan doesn't: a line-item budget, a draw schedule, inspections, lien waivers from contractors, a holdback called retainage, and often an interest reserve to pay interest while the building earns nothing.

Why it matters for lenders

Construction lending has more ways to go wrong than lending on a finished property. Costs can run over, contractors can fail, and the market can change before the building is done. US bank regulators expect each draw to match verified work and the budget to stay "in balance," meaning the undrawn loan plus the borrower's remaining equity can still pay to finish the job.

The risk also changes over time. Early on, the lender has lent against little more than a site. If the project stalls halfway, the lender may hold a lien on an unfinished building worth less than the loan. Claims from unpaid contractors can make that worse, since in some states those liens can take priority over the lender. So many lenders treat every draw as a credit decision.

How it works in practice

A private lender closes a loan to build six townhomes. At closing, the loan administrator books the approved budget by line, the draw schedule, the retainage rate and the interest reserve. Each month, the builder submits a draw request. An inspector reports percent complete by line. The administrator approves what the inspection supports, collects lien waivers for the prior draw, orders a title update, holds back retainage, and sends the draw for a second approval before funding.

When the budget lives in one workbook and draws in another, staff can't quickly say what is left to fund or whether the project is still in balance. Keeping the budget, draws and documents on the same real estate lending record makes those questions easy to answer.