When Do Payments Start on a Construction Loan?
Construction loan payments aren't straightforward. Learn their unique start and evolution, from initial draws to full repayment, tied to your project's progress.
A construction loan provides specialized financing for building a new home or undertaking extensive renovations. Unlike a traditional mortgage, funds are disbursed in stages, aligning the payment schedule with the actual building process. This means the borrower does not receive the full loan amount upfront, and payment obligations reflect the progressive nature of construction.
Understanding Construction Loan Disbursement
Construction loans operate through “draws” or “progress payments.” Funds are released in stages as specific construction milestones are met, such as foundation completion, framing, or plumbing and electrical system installation. This staged disbursement helps lenders manage risk, ensuring funds are used for their intended purpose and the project progresses as planned.
Before each draw, an inspection is conducted by the lender or a third-party inspector to verify work corresponds to agreed milestones and budget. The general contractor submits a draw request, including documentation such as invoices and receipts. This process ensures accountability and provides a clear audit trail for how the loan funds are utilized.
Interest begins to accrue only on funds actually drawn, not on the full approved loan amount. As construction progresses and more funds are drawn, the outstanding loan balance increases, leading to a gradual increase in the monthly interest payment. This provides a financial advantage during the early stages of construction.
Interest-Only Payments During Construction
Payments on a construction loan begin shortly after the first draw. During the construction phase, these initial payments are “interest-only,” meaning the borrower is responsible for the accrued interest on the disbursed portion. This payment structure helps keep monthly expenses lower while the property is under construction.
The amount of interest paid each month will fluctuate because it is calculated based on the increasing principal balance drawn. As the builder completes more phases of construction and requests additional draws, the total amount borrowed increases, and the monthly interest payment rises.
This interest-only period provides borrowers with financial flexibility, allowing them to manage other construction-related expenses without the burden of principal payments. This phase typically ranges from 12 to 18 months, aligning with standard construction timelines.
Transitioning to Permanent Loan Payments
Once construction is complete and the property is ready for occupancy, the construction loan transitions to a different payment structure. This shift occurs after a final inspection and the issuance of a Certificate of Occupancy (CO). A Certificate of Occupancy certifies the building is safe, habitable, and complies with local building codes.
There are two primary methods for this transition. The first is a “construction-to-permanent” loan, also known as a single-close loan. With this type, the construction loan automatically converts into a standard long-term mortgage once construction is finished. This streamlined process avoids a second closing, potentially saving the borrower additional closing costs and application fees.
The second method involves a separate refinance, often referred to as a “two-time-close” or “construction-only” loan. The borrower obtains a new, independent permanent mortgage to pay off the short-term construction loan. This approach offers flexibility, allowing the borrower to shop for the best rates and terms for their long-term financing. Full principal and interest payments begin at this point, mirroring a traditional home loan.
Key Factors Affecting Payment Timelines
Several elements can influence the payment timeline for a construction loan. Construction delays, such as weather delays, material shortages, or contractor availability, can prolong the construction period beyond initial estimates. This means borrowers continue to make interest-only payments for a longer duration, which can increase the total interest paid.
Conversely, an early completion of construction can accelerate the transition to permanent financing. The specific terms negotiated with the lender also play a significant role. Loan agreements outline draw schedules, interest rates (often variable during construction), and conversion clauses, all of which impact the payment timeline.
The type of construction loan chosen, whether a single-close construction-to-permanent loan or a two-close construction-only loan followed by a separate mortgage, directly affects the transition process and associated timelines. A construction-to-permanent loan typically has a more predictable conversion timeline as the permanent financing terms are often established upfront.