What is a Construction Loan and how do they work?


This is an introduction to construction loans! Unlike a mortgage, where money is loaned all at once, a construction loan is often “drawn” in stages. As construction progresses, money will be transferred through the "draw" process, as discussed below. A construction loan is a short-term, higher-interest loan that provides the funds required to build a construction project.


A Step-By-Step Process


A construction loan begins with a loan application process with your lender, including a loan closing. The closing is when you review and sign the legal documents establishing your loan and its terms. This then establishes the amount of money you have available to request (also called “draw”).



When construction on your project begins, you will receive invoices and pay applications from the contractors on your job. You likely will also receive invoices from other professional consultants, which could include architects, engineers, etc. Additionally, you will also incur other construction-related costs, like interest on the construction loan. As a best practice, you should have internal processes to review and approve all the billings on your project and record them against your project budget.


On a monthly basis, you will submit a “draw request” to your bank, requesting money available from your construction loan, to use to pay the contractors or vendors who have provided materials or perform services for your construction project. Below is the information often provided to the bank in the format of a construction pay application in these categories:

  • Original Budget

  • Change Orders

  • Revised Budget

  • Previous Billings

  • Current Period Billing

Your bank will likely require copies of the invoices and pay applications from your contractors and vendors as support. They may also require copies of lien waivers you’ve received from your contractors. (Generally, contractors providing materials or labor for a construction project have lien rights against the project. As you pay contractors, you should receive lien waivers, which is a document signed by the contractor waiving their rights to that dollar amount due to receiving payment). Lien waivers are important legal documents to protect you and your property and also protect the bank since your loan is often backed by your property.



When the bank receives your draw request, the lender will need to approve the request. The size, scope, and timing of the approval will vary depending on the size of the project and the bank’s processes. This may include a review of the request and supporting documentation by the loan officer. It may include a site visit by someone from the bank or an independent site inspector. This helps the bank verify that the funds on the construction loan are being used for their intended use to construct or improve a site or building.


After the draw request is approved, the bank will fund the draw. This often means they will deposit the requested money directly into your business’s checking account or by paying the company you’ve contracted with to do the work.


When the draw request is funded, this also increases the amount outstanding on your construction loan and decreases the amount of the loan that is available to draw in the future.



Final Thoughts


When your project is done, if the finished product is something you will continue to own, banks often have a specified payment schedule similar to a mortgage. If you constructed something to sell, the balance of the construction loan will need to be paid off before you can receive any remaining sales funds.

Overall, the construction draw process goes smoothly when you have proper project financial tracking, communication with a trusted lender, and solid accounting practices.

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