How Much Is Interest on a Construction Loan?

A construction loan is a specific type of financing designed to cover the costs associated with building a new home or undertaking a significant renovation project. Unlike a traditional mortgage, which finances an existing property, a construction loan provides funds in stages as the building progresses.

Key Characteristics of Construction Loan Interest Rates

Interest rates for construction loans are usually variable, meaning they can change throughout the construction period. These rates often tie to a recognized financial benchmark, such as the Prime Rate or the Secured Overnight Financing Rate (SOFR), plus an additional percentage known as the margin.

Construction loan interest rates are generally higher than those for a standard, permanent home loan. This reflects the increased risk for lenders when financing an incomplete property, as there is no finished asset to secure the loan until construction is complete. During the building phase, borrowers typically make interest-only payments, meaning they pay only the accrued interest on the funds that have been disbursed.

How Construction Loan Interest is Calculated and Paid

Interest on a construction loan is calculated differently because funds are not disbursed as a single lump sum. Lenders release money through a “draw schedule” as specific stages of the construction project are completed. This means interest is only charged on the portion of the loan that has already been advanced, not on the full approved loan amount.

For example, if a borrower has an approved $400,000 construction loan but has only drawn $100,000, interest is calculated only on that $100,000. As more funds are drawn, the outstanding balance increases, and the monthly interest payment also rises. Lenders typically require proof of completed work, such as invoices and inspections, before releasing each new draw. Payments during the construction period remain interest-only, and the principal repayment phase usually begins once the project is finished and the loan transitions into a permanent mortgage.

Factors Influencing Your Specific Construction Loan Interest

Several factors influence the interest rate a borrower receives on a construction loan. A strong credit score and a solid financial history are important, as they indicate a borrower’s reliability and ability to manage debt. Higher scores generally lead to more favorable rates.

The loan-to-value (LTV) ratio, which compares the loan amount to the property’s appraised value, also plays a role. A larger down payment or significant equity in the land can result in a lower interest rate, as it reduces the lender’s risk. The complexity and type of the construction project, along with the builder’s experience and financial standing, can influence rates. The duration of the construction phase, or loan term, and broader economic conditions, including prevailing local market rates, contribute to the final interest rate offered.

Different Construction Loan Structures and Their Interest Considerations

Construction loans come in different structures, each impacting interest rates and payment processes. A common option is the construction-to-permanent loan, often called a “single-close” loan. With this structure, one loan functions as a construction loan and then automatically converts into a permanent mortgage once construction is complete. The interest rate during the construction phase is typically variable, but the permanent phase often transitions to a fixed or adjustable rate. This single closing can reduce overall closing costs compared to separate loans.

In contrast, a construction-only loan, or “two-close” loan, is a short-term financing option solely for the construction phase. Once the project is finished, the borrower must secure a separate, traditional mortgage to pay off the construction loan. Interest rates on these short-term loans may be higher, and borrowers face the risk of market rate fluctuations when applying for permanent financing. Owner-builder loans, where the homeowner acts as the general contractor, may carry higher interest rates due to increased perceived risk for the lender.