A construction loan is a short-term financing option used to fund the construction or renovation of a residential or commercial property. It provides funds in stages or “draws” as the construction progresses. Once the project is completed, the borrower typically refinances the construction loan into a traditional mortgage or pays it off in full.

Here are key aspects of a construction loan:

1. Short-Term Loan: Construction loans are temporary and usually have terms ranging from six months to a few years. The loan is structured to cover the construction period and then needs to be refinanced or paid off when the project is finished.

2. Interest and Payments: During the construction phase, borrowers may only pay interest on the funds disbursed for the construction. These payments are often interest-only or based on the amount drawn. After construction, the loan may be converted to a traditional mortgage, and regular principal and interest payments begin.

3. Draws and Inspections: The loan is disbursed in stages, known as “draws,” typically tied to construction milestones. Before each disbursement, the lender usually conducts inspections to ensure the work has been completed as per the plan and to determine the amount to be released.

4. Construction Plan and Budget: Borrowers need a detailed construction plan, including architectural designs, permits, and a budget outlining costs for materials, labor, and other expenses. Lenders assess the feasibility and risk of the project based on these plans.

5. Loan-to-Value (LTV) Ratio: Construction loans often have lower LTV ratios compared to traditional mortgages. Lenders may finance a percentage of the project’s appraised value or the cost of construction, whichever is lower.

6. Qualification: Obtaining a construction loan may require a more rigorous approval process compared to regular mortgages. Lenders assess the borrower’s creditworthiness, income, assets, and the project’s feasibility.

7. Conversion to Permanent Loan: Once construction is complete, borrowers usually refinance the construction loan into a permanent mortgage or secure a long-term financing option to repay the construction loan.

Construction loans can be used for various projects, including building a new home, major renovations, or commercial property development. These loans provide the necessary capital during the construction phase, enabling borrowers to complete their projects before transitioning to long-term financing.