Construction loans are short-term credit facilities provided to real estate developers to fund the cost of building new properties or completing major renovations. Unlike permanent mortgages that finance stabilized, income-producing assets, construction loans finance assets that do not yet generate income — creating a unique risk profile that requires specialized underwriting and active monitoring.
Construction loan proceeds are not advanced in a lump sum at closing; they are disbursed in stages — "draws" — as construction progresses and milestones are met. Before each draw is funded, the lender (or its inspector) verifies that the work described in the draw request has been completed in compliance with the approved plans, budget, and specifications. The draw request process protects the lender against funding work that hasn't been performed and ensures the remaining unfunded budget is adequate to complete the project.
The loan-to-cost (LTC) ratio is the primary sizing constraint for construction loans, measuring the loan as a percentage of the total project cost (land + hard construction costs + soft costs). Most lenders limit LTC to 65–75% for ground-up development projects, ensuring the borrower has meaningful equity at risk. Loan-to-value (LTV) based on the "as-complete" appraised value is a secondary constraint.
Interest reserve is a distinctive feature of construction lending. During construction, the property generates no income to service interest payments. To manage this, lenders typically include an interest reserve in the construction budget — a portion of loan proceeds set aside to fund interest payments during the construction period. The interest reserve is released as a draw each month to cover accrued interest, allowing the borrower to avoid cash payments during construction.
Construction loan risk is substantially higher than permanent mortgage risk. The primary risks include: completion risk (the project may not be completed on time or budget), lease-up/sales risk (the completed project may not achieve projected occupancy or pricing), market risk (real estate conditions may deteriorate during the construction period), and contractor default risk. Lenders mitigate these risks through payment and performance bonds, budget contingency requirements, completion guarantees from creditworthy sponsors, and rigorous pre-loan due diligence.