Construction loans are higher-interest, shorter-term loans that are used to cover the cost of building or rehabilitating your home. Unlike a traditional home loan, which is based on the fair market value of the home and determined by the home’s condition in comparison to other recent sales, construction loans are based on what the projected value of the home will be once the work is complete.
Traditional loans are paid out by a mortgage company to cover the cost of the home in one lump-sum at closing. In contrast, construction loans are paid out in installments. A bank will pay the builder as various phases of the building process are completed. The total cost is transferred to you once the entire project is finished.
These installments are called “draws.” Each draw reimburses the builder for the costs needed to cover that phase of building, meaning that they—or you—have to have enough cash on hand to cover these costs upfront. Before each draw can be made, the bank will do an inspection to verify the estimated cost of the current phase of building, as well as how well the builder is moving on their projected timeline.