Do You Pay on a Construction Loan While Building?

Building a new home or undertaking a significant renovation often involves securing a construction loan. These specialized financial products are designed to fund the various stages of a building project, differing notably from traditional mortgages used to purchase existing properties. Payments are typically required on these loans during the construction phase. Understanding how these payments function is a key aspect of managing your homebuilding finances.

Understanding Payments During Construction

Construction loans typically feature an interest-only payment structure throughout the building phase. The full loan amount is not disbursed upfront; instead, funds are released incrementally as construction progresses. Interest is calculated solely on the portion of the loan that has been “drawn” or disbursed, rather than on the entire approved loan amount. This allows borrowers to manage cash flow effectively while their new home is under construction.

The process of disbursing funds occurs through a series of “draws.” As the builder completes specific milestones, such as foundation work, framing, or roofing, they submit a draw request to the lender. Before releasing funds, the lender often conducts an inspection to verify that the work has been completed. Each successful draw increases the outstanding balance of the loan, leading to a gradual increase in the monthly interest payment.

For example, if the initial draw is $50,000 from a $300,000 loan, your interest payment for that period will only be based on the $50,000. As subsequent draws are made, perhaps increasing the disbursed amount to $150,000, your monthly interest payment will then be calculated on this larger sum. This means your payment amount will steadily climb as more of the construction is completed. Principal payments are generally not required during this phase, which provides financial flexibility.

Loan Structures and Their Payment Implications

The type of construction loan chosen significantly impacts the payment process. Two primary structures are common: the construction-to-permanent loan and the construction-only loan. Each has distinct implications for how and when payments are made.

A construction-to-permanent loan, often referred to as a single-close or one-time close loan, combines the financing for both the construction phase and the long-term mortgage into a single loan with one closing process. During the construction period, payments typically remain interest-only, based on the funds drawn. Once construction is complete, the loan automatically converts into a traditional principal and interest mortgage without the need for a second closing or additional closing costs. This conversion simplifies the borrower’s experience by avoiding separate applications and underwriting processes.

Conversely, a construction-only loan is a short-term financing option designed solely to cover the costs incurred during the building phase. Payments on this type of loan are also typically interest-only while the home is under construction, calculated on the disbursed funds. Upon the completion of construction, the entire balance of the construction-only loan becomes due. This necessitates that the borrower secure a separate, new permanent mortgage to pay off the construction loan. This structure involves two distinct loans and, consequently, two separate closing processes, each with its own associated fees.

Moving from Construction to Permanent Financing

The transition from the construction phase to long-term financing marks a significant shift in payment obligations. This stage differs depending on whether a construction-to-permanent loan or a construction-only loan was utilized.

For borrowers with a construction-to-permanent loan, the process involves a seamless “conversion.” Once construction is fully complete, typically evidenced by a certificate of occupancy and final inspections, the loan automatically transitions from the interest-only construction phase to a traditional principal and interest repayment schedule. Monthly payments will increase as they now include both the repayment of the borrowed principal and the accrued interest over the loan’s term, usually 15 or 30 years. The terms, including the interest rate, are generally established and locked in at the initial single closing, providing predictability for the borrower’s future payments.

In the case of a construction-only loan, the completion of the home requires the borrower to obtain separate permanent financing. This typically involves applying for a new, traditional mortgage to pay off the short-term construction loan. The borrower will go through a new underwriting process, which includes credit checks, income verification, and an appraisal of the newly completed home. Once approved, a second closing takes place, at which point the funds from the new permanent mortgage are used to satisfy the outstanding balance of the construction loan. Following this, the borrower begins making regular principal and interest payments on their new, long-term mortgage. This two-step process allows borrowers to potentially shop for the most competitive mortgage rates available at the time of conversion, but it also means incurring a second set of closing costs.