Construction loans are among the most complex and highest-risk financing structures in real estate. The risks are manageable - but only if you understand them before you break ground.
A construction loan is short-term financing that funds the cost of building or substantially renovating a property. Unlike a conventional mortgage where the lender advances the full loan amount at closing, a construction lender holds funds in reserve and releases them in stages as construction progresses. This staged disbursement approach protects the lender from funding a project that stalls partway through - but it also creates cash flow dynamics that borrowers must plan around carefully.
Interest on a construction loan typically accrues only on the drawn balance, not the total loan commitment. A borrower with a $2 million construction loan who has drawn $500,000 pays interest on $500,000, not $2 million. As draws increase, so do interest payments. Most construction loans require interest-only payments during the construction period, with the full principal balance due at loan maturity or conversion to permanent financing.
The construction period typically runs 12 to 24 months depending on the project scope. At the end of that period, the loan must be repaid. For borrowers using standalone construction financing, this means obtaining a new permanent loan within the construction period. For borrowers using construction-to-permanent financing, the loan converts automatically. Both paths carry risk that must be understood before the first dollar is drawn.
Construction-to-Permanent (One-Time Close): The loan automatically converts from construction financing to a permanent mortgage when the project is complete. One closing. Rate locked at the start. No second qualification required.
Standalone Construction Loan: A separate short-term loan for the construction period only. When construction is complete, the borrower obtains a new permanent loan to pay off the construction loan. Two closings. Two sets of fees. Rate risk on the permanent loan.
The right structure depends on your project, your lender options, and your risk tolerance. Both have advantages and disadvantages that require evaluation.
A draw request is a formal application to the lender to release a portion of the construction reserve. The borrower submits documentation showing that specific work has been completed - contractor invoices, lien waivers, and sometimes photos or architect certification. The lender sends an inspector to verify completion before approving the draw.
The draw process adds time between work completion and payment. Contractors must be paid even when the draw is pending. Borrowers need bridge funding or working capital to manage timing gaps.
Some construction loans use milestone-based draws tied to specific construction stages - foundation, framing, rough mechanicals, drywall, finishes, certificate of occupancy. Others use percentage-based draws where a percentage of the construction budget is released as a percentage of work is completed. Milestone-based draws are clearer but less flexible; percentage-based draws are more flexible but require more inspection resources.
Know your draw structure before closing. Vague draw definitions create disputes between borrower, contractor, and lender about what has been "completed."
Most construction lenders require a third-party inspector to verify completion before approving draws. The inspector works for the lender, not the borrower. Inspection timing is at the lender's discretion - delays in scheduling inspections directly delay draw approvals and can stall construction. Some loan structures include a maximum draw approval timeline; many do not.
Ask before closing: How quickly does the lender process draw requests? What is the typical time from draw submission to funded disbursement? Slow draw processes are one of the most common sources of cost overruns.
Construction lenders typically require lien waivers from contractors and subcontractors as part of the draw documentation. A lien waiver is a statement that the contractor releases their right to file a mechanic's lien against the property for the work covered by that payment. Conditional lien waivers are conditioned on receipt of payment; unconditional waivers release the lien right regardless. Lenders often require unconditional waivers before disbursing a draw, which creates a coordination challenge between lender payment and contractor release.
Construction budgets rarely survive contact with reality without change orders. Material costs fluctuate. Design modifications get added. Unforeseen conditions - poor soil, unexpected structural issues, weather delays - add cost without adding progress. When the construction budget runs short, the remaining loan funds may be insufficient to complete the project.
In most construction loan structures, the borrower is required to contribute additional equity to cover cost overruns before the lender will continue funding draws. A borrower who has committed all their available capital to the original project and cannot cover overruns faces a genuine crisis: the building is incomplete, the loan is in a potential default situation, and completion seems impossible without additional funding that is not available.
Coventry Enterprises consistently recommends that borrowers evaluate construction budgets with a realistic contingency - typically 10% to 15% of hard construction costs on new construction and higher on renovation projects where unknown conditions are more likely. Some construction loans include a contingency reserve line item that can be drawn if needed; others do not. The presence and scope of the contingency reserve is one of the first things we examine in any construction loan review.
Construction loans mature on a specific date. If the project is not complete and the borrower cannot obtain permanent financing by maturity, the loan defaults. Delays caused by weather, labor shortages, supply chain problems, permitting delays, or design changes can all push completion past the maturity date. Borrowers who underestimate construction timelines are the most vulnerable.
Extension rights are critical in construction lending. Before closing, a borrower should understand exactly what conditions must be satisfied to obtain an extension, how many extensions are available, what they cost, and how much total time they provide. An extension right that requires no defaults and current documentation may be unavailable precisely when it is most needed - when construction delays have created a covenant breach or documentation deficiency.
Under state law, contractors and subcontractors who have not been paid for labor or materials may file mechanic's liens against the property. A mechanic's lien can cloud title, trigger default provisions in the construction loan, and interfere with the ability to obtain permanent financing at completion. Most construction loans include requirements that the borrower indemnify the lender against mechanic's liens and obtain releases before draws are funded.
Borrowers who hire contractors without rigorous payment documentation and lien waiver practices are creating unnecessary risk. A general contractor who does not pay subcontractors - even if the general contractor received payment from the borrower - can expose the property to subcontractor liens. Coventry Enterprises examines mechanic's lien provisions and indemnification requirements in every construction loan review.
The construction loan lender approves the contractor and the budget based on documents at origination. What happens if the contractor performs poorly, abandons the project, or becomes insolvent during construction? Most construction loans require lender approval for contractor changes. Some loans include completion guaranty provisions that give the lender remedies against the borrower if the contractor fails. Others leave the borrower entirely exposed to contractor performance risk with no mechanism for recovery beyond the legal system.
Before selecting a construction lender, understand their process for contractor change approvals. A lender who requires extensive requalification of a new contractor after an abandonment can add months of delay to a crisis situation that is already expensive and time-pressured.
Construction loan documents define a wider range of default events than permanent mortgage documents. Beyond missing a payment, events of default in construction lending commonly include:
Each of these provisions has a cure period - or sometimes no cure period at all. Understanding which defaults give you time to fix the problem and which ones trigger immediate lender remedies is essential.
A construction loan review from Coventry Enterprises focuses on the specific risks of the construction period and the transition to permanent financing. The key areas we examine include the draw schedule and milestone definitions, contingency reserve provisions, completion deadline and extension rights, default events specific to construction, mechanic's lien indemnification scope, contractor change procedures, personal guaranty terms, and the permanent financing conversion conditions for one-time close loans.
For one-time close loans, the permanent loan terms set at origination deserve as much scrutiny as the construction period terms. The rate, term, amortization, and covenants of the permanent loan all become binding when construction is complete - regardless of what the market looks like at that time. If the permanent loan terms would have been unacceptable in a standalone permanent mortgage, they are equally unacceptable embedded in a one-time close structure.
The lender holds loan funds in a reserve and releases them in stages (draws) as construction milestones are completed and verified by inspection. Interest accrues only on drawn funds. The loan matures when construction is complete and must be repaid or converted to permanent financing.
A one-time close loan converts automatically to permanent financing when construction is done - one closing, rate locked upfront. A standalone construction loan is separate and requires a new permanent loan to pay it off at completion - two closings, two sets of fees, rate uncertainty on the permanent loan.
A schedule specifying when and how the lender releases construction funds during building. Draws are triggered by completion of defined milestones confirmed by inspection. Delays in draw approvals increase carrying costs and can cause cash flow problems for the borrower and general contractor.
The borrower is typically required to contribute additional equity to cover cost overruns before the lender funds further draws. Borrowers without available capital to cover overruns can find themselves unable to complete the project, triggering default. A realistic contingency reserve (10% to 15%+ of hard costs) is essential planning.
Contractors and subcontractors who are not paid can file mechanic's liens against the property. These liens can cloud title, trigger construction loan default provisions, and block permanent financing. Rigorous lien waiver practices throughout construction are essential protection.
Yes. We review construction loan documents for draw schedule mechanics, contingency provisions, completion default triggers, mechanic's lien requirements, extension rights, contractor change procedures, and guaranty scope. Our written report delivers plain-language findings and negotiation recommendations before you close.