How Does a Ground Up Construction Loan Work? Complete Guide to Draws, Phases & Permanent Financing

How Does a Ground Up Construction Loan Work? Complete Guide to Draws, Phases & Permanent Financing

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Building a property from the ground up is one of the most rewarding—and complex—financial undertakings you can pursue. Unlike buying an existing building with a traditional mortgage, ground up construction loans work fundamentally differently, funding your project in phases as construction progresses rather than providing a lump sum at closing.

Understanding how these loans function—from the initial draw to conversion into permanent financing—is essential for any developer, investor, or business owner planning new construction. In this comprehensive guide, we'll walk through every aspect of how ground up construction loans work so you can approach your project with confidence.

What Is a Ground Up Construction Loan?

A ground up construction loan is a short-term financing solution specifically designed to fund the construction of a new building on vacant land. Unlike traditional mortgages that finance existing properties, construction loans are project-based financing that covers the costs of transforming raw land into a completed structure.

These loans differ from traditional mortgages in several key ways:

• Short-term duration: Typically 12-24 months versus 15-30 years for permanent loans
• Progressive funding: Money is released in draws as construction milestones are completed
• Interest-only payments: You only pay interest on the amount disbursed, not the full loan
• Higher interest rates: Construction carries more risk, so rates are typically 1-3% higher than permanent financing
• Requires exit strategy: Must be repaid or converted to permanent financing upon completion

The Draw System: How Construction Loan Funding Actually Works

The most distinctive feature of ground up construction loans is the draw system. Rather than receiving your full loan amount at closing, funds are released incrementally as your project reaches specific construction milestones.

Why Lenders Use the Draw System

From the lender's perspective, the draw system protects their investment. They're not funding a completed property with established value—they're funding a project in progress. By releasing funds in stages and requiring inspections before each draw, lenders ensure:

1. Construction is actually progressing as planned
2. Their money is being used appropriately
3. The property value at any given point covers the amount disbursed
4. Problems can be identified and addressed before additional funds are released

How the Draw Process Works Step by Step

Here's what happens each time you request a construction draw:

Step 1: Complete the Work Your contractor completes the work required for that construction phase according to the approved plans and budget.

Step 2: Submit a Draw Request You or your contractor submits a formal draw request to the lender, including invoices, lien waivers from subcontractors, and photos documenting completed work.

Step 3: Lender Inspection The lender sends an inspector (often a third-party construction monitor) to verify the work has been completed as claimed and matches the approved plans.

Step 4: Title Update A title company issues an updated endorsement confirming no new liens have been filed against the property.

Step 5: Funds Released Once everything checks out, the lender releases the draw amount—typically within 3-7 business days of inspection approval.

Step 6: Pay Contractors You use the draw funds to pay your general contractor, who then pays subcontractors and suppliers.

This process repeats for each construction phase until the project is complete.

The Five Construction Phases and Their Typical Draws

While every project is unique, most ground up construction loans are structured around five major phases. Understanding these phases helps you anticipate cash flow needs and plan your draw schedule.

Phase 1: Site Work and Foundation (15-20% of Loan)

The first draw covers everything needed to prepare the site and establish the foundation:

• Land clearing and grading
• Excavation
• Underground utilities (water, sewer, electrical conduits)
• Foundation footings and pouring
• Waterproofing and drainage systems

This phase is critical because it establishes the literal foundation for everything that follows. Delays or problems here ripple through the entire project timeline.

For larger projects involving significant earth moving, our horizontal construction projects financing can provide specialized structures.

Phase 2: Framing and Structural Work (25-30% of Loan)

The second draw is typically the largest, covering the structural skeleton of your building:

• Floor systems
• Wall framing (wood, steel, or concrete)
• Roof trusses and sheathing
• Windows and exterior doors
• Exterior sheathing and weather barrier

After this phase, your building has taken shape and is protected from weather, allowing interior work to proceed regardless of conditions.

Phase 3: Mechanical Rough-In (20-25% of Loan)

The third draw funds the critical systems that make your building functional:

• Electrical wiring and panel installation
• Plumbing supply and drain lines
• HVAC ductwork and equipment
• Fire suppression systems (if required)
• Low-voltage wiring (data, security, audio)
• Insulation installation

These systems must be inspected before walls are closed, making this phase inspection-intensive.

Phase 4: Interior Finishes (20-25% of Loan)

The fourth draw transforms your structure into a usable space:

• Drywall installation and finishing
• Interior painting
• Flooring (tile, hardwood, carpet)
• Cabinetry and countertops
• Interior doors and trim
• Plumbing and electrical fixtures
• Appliance installation

This phase typically has the most line items and requires careful coordination between trades.

Phase 5: Final Completion (10-15% of Loan)

The final draw covers everything needed to obtain your Certificate of Occupancy:

• Exterior finishes (siding, brick, stucco)
• Landscaping and hardscaping
• Driveways and parking areas
• Final inspections and punch list items
• Certificate of Occupancy

Most lenders withhold a retainage (typically 5-10% of the total loan) until all punch list items are completed and final inspections pass.

Understanding Interest-Only Payments During Construction

One of the most advantageous features of construction loans is that you only pay interest on the amount that has been disbursed—not the full loan amount. This keeps your monthly payments manageable during the building phase when the property isn't generating income.

How Interest Accrues on Draws

Here's a practical example of how interest works on a $500,000 construction loan at 7% annual interest:

After Draw 1 ($100,000 disbursed): Monthly interest = $100,000 x 7% / 12 = $583

After Draw 2 ($225,000 total disbursed): Monthly interest = $225,000 x 7% / 12 = $1,313

After Draw 3 ($325,000 total disbursed): Monthly interest = $325,000 x 7% / 12 = $1,896

As you can see, your monthly payment increases with each draw. By the end of construction, you're paying interest on the full loan amount.

Interest Reserve Accounts

Most construction lenders allow (or require) you to establish an interest reserve—funds set aside from your loan proceeds to cover monthly interest payments during construction. This means you don't pay out of pocket while building.

A typical interest reserve calculation:

• $500,000 loan at 7% interest
• 12-month construction period
• Average outstanding balance: approximately $300,000 (since draws happen progressively)
• Estimated interest reserve needed: $300,000 x 7% = $21,000

Lenders build this reserve into your total loan amount, so factor it into your equity calculations.

Converting to Permanent Financing: Your Exit Strategy

Construction loans are short-term by design—they must be repaid or converted to permanent financing once building is complete. This transition is a critical part of how ground up construction loans work.

Option 1: Construction-to-Permanent (One-Time Close) Loans

The most convenient option is a construction-to-permanent loan, also called a single-close or one-time-close loan. With this structure:

• You close once at the beginning of construction
• The loan automatically converts to permanent financing upon completion
• You lock in your permanent rate upfront (or at conversion, depending on the program)
• You avoid paying closing costs twice
• The transition is seamless with no requalification required

This option works well for borrowers who want certainty and simplicity.

Option 2: Two-Time Close (Separate Construction and Permanent Loans)

Some borrowers prefer separate construction and permanent loans:

• Close on a construction loan to build
• Upon completion, close on a new permanent mortgage to pay off the construction loan
• Shop for the best permanent rates at completion
• Flexibility to choose different lenders for each phase
• Two sets of closing costs

This option can be advantageous if permanent rates drop significantly during construction or if you want to shop multiple permanent lenders.

What Happens at the Conversion

When your construction loan converts to (or is replaced by) permanent financing:

1. Certificate of Occupancy: Lender requires proof the building is complete and habitable
2. Final Inspection: Confirms all work matches approved plans and budget
3. As-Built Appraisal: Property is appraised at its completed market value
4. Rate Lock (if applicable): Your permanent interest rate is finalized
5. Loan Modification/New Closing: Documents are executed for permanent loan terms
6. First Permanent Payment: Typically due 30-60 days after conversion

Use our commercial mortgage calculator to estimate your permanent loan payments once construction is complete.

Qualifying for a Ground Up Construction Loan

Understanding qualifications helps you prepare before applying. Construction lenders evaluate:

Borrower Qualifications

• Credit Score: Minimum 680, with 720+ offering better terms
• Experience: Construction or development experience strengthens applications
• Financial Reserves: Cash to cover contingencies and potential cost overruns
• Debt-to-Income: Personal DTI matters for recourse loans
• Net Worth: Typically want to see net worth equal to or exceeding loan amount

Project Qualifications

• Detailed Plans: Architectural drawings, specifications, and permits
• Construction Budget: Line-item budget with contractor bids
• Project Timeline: Realistic schedule with milestones
• Contractor Qualifications: Licensed, bonded, experienced general contractor
• Feasibility Study: Market analysis showing demand for your project type

Collateral Requirements

• Down Payment: Typically 20-30% of total project costs
• Land Equity: If you own the land, its value may count toward equity
• Loan-to-Cost (LTC): Most lenders cap at 75-80% of total project costs
• Loan-to-Value (LTV): Based on projected completed value, typically 65-75%

For vertical construction financing on multi-story projects, lenders may have additional requirements around structural engineering and phased occupancy.

Key Terms You Need to Know

Understanding construction loan terminology helps you communicate effectively with lenders:

Draw Schedule: The predetermined plan for when and how funds will be released throughout construction.

Retainage: A percentage (usually 5-10%) held back from each draw until project completion to ensure contractors finish all work.

Change Order: A formal modification to the original construction contract, affecting scope, timeline, or budget.

Holdback: Similar to retainage; funds held until specific conditions are met.

Soft Costs: Non-construction expenses like permits, architectural fees, engineering, and legal costs.

Hard Costs: Actual construction expenses for labor, materials, and equipment.

Cost Overrun: When actual costs exceed the approved budget, potentially requiring additional equity.

Construction Monitor: Third-party inspector who verifies work completion before draws.

As-Complete Appraisal: Appraisal estimating the property's value once construction is finished.

Common Challenges and How to Navigate Them

Ground up construction loans involve more moving pieces than traditional mortgages. Here's how to handle common challenges:

Cost Overruns

Construction costs can exceed initial budgets due to material price increases, design changes, or unforeseen conditions. Protect yourself by:

• Building a 10-15% contingency into your budget
• Getting fixed-price contracts where possible
• Having cash reserves beyond your down payment
• Communicating with your lender early if overruns emerge

Construction Delays

Weather, permit issues, labor shortages, or material delays can extend your timeline. Manage delays by:

• Building realistic buffers into your schedule
• Monitoring progress weekly
• Addressing issues immediately rather than hoping they resolve
• Communicating with your lender—extensions may be available

Draw Disputes

Sometimes lenders and borrowers disagree about whether work justifies a draw. Minimize disputes by:

• Documenting everything with photos and written records
• Having clear specifications in your construction contract
• Building good relationships with your lender and inspector
• Using experienced contractors familiar with construction lending

Interest Rate Risk

Construction loan rates are typically variable, meaning they can increase during your project. Manage this by:

• Factoring potential rate increases into your budget
• Considering construction-to-permanent loans with rate locks
• Building interest rate increases into your contingency

Is a Ground Up Construction Loan Right for You?

Ground up construction loans are ideal when:

• You're building on vacant land you own or are purchasing
• You have detailed plans and a qualified contractor lined up
• You can provide 20-30% equity
• You have strong credit and financial reserves
• You understand and accept the complexity compared to traditional mortgages

They may not be the best fit if:

• You're looking for simplicity and minimal paperwork
• You can't handle potential cost overruns
• Your credit or finances need work
• You're not prepared for the intensive draw process

Ready to Start Your Ground Up Construction Project?

Ground up construction loans are powerful financing tools that make new development possible. While they're more complex than traditional mortgages, understanding how they work—the draw system, construction phases, interest accrual, and permanent financing conversion—positions you for success.

The key is preparation: detailed plans, realistic budgets, qualified contractors, and a lender who specializes in construction financing.

If you're ready to explore ground up construction financing for your project:

1. Contact our construction loan specialists for a personalized consultation
2. Estimate your costs using our mortgage calculator tools
3. Apply for a construction loan to start the pre-qualification process

Our team has helped hundreds of borrowers navigate ground up construction financing. We understand the nuances of draw schedules, contractor coordination, and conversion to permanent financing—and we're here to make your project a success.

Speak with our team today to discuss your specific project needs.

Frequently Asked Questions

How long does it take to get approved for a ground up construction loan? With complete documentation including plans, permits, contractor information, and financials, expect 30-60 days from application to closing. The approval timeline depends heavily on your preparedness.

What's the difference between Loan-to-Cost and Loan-to-Value? Loan-to-Cost (LTC) is your loan amount divided by total project costs (land, construction, soft costs). Loan-to-Value (LTV) is your loan divided by the property's completed appraised value. Lenders use both metrics—typically capping LTC at 75-80% and LTV at 65-75%.

Can I be my own general contractor? Some lenders allow owner-builders, but many prefer licensed general contractors due to the additional risk. If you want to serve as your own GC, expect to demonstrate construction experience and potentially face stricter terms.

What happens if I run out of money mid-construction? This is every lender's nightmare. You'll need to inject additional equity, find a partner, or risk the project stalling. This is why contingency reserves and realistic budgets are essential.

Are construction loan interest rates fixed or variable? Most construction loans have variable rates tied to Prime Rate or another index. Some lenders offer fixed-rate construction loans at a premium. Construction-to-permanent loans may allow you to lock your permanent rate at closing or during construction.

How often can I request draws? Most lenders allow draws upon completion of each major phase—typically 4-6 draws over the construction period. Some lenders offer more frequent draws (monthly), which can help with contractor cash flow.

What if my contractor abandons the project? This is why lender contractor approval matters. You'd need to find a replacement contractor, potentially rebid portions of work, and work with your lender to restructure the remaining draws. Insurance and bonding can help recover costs.

About Clear House Lending: We specialize in ground up construction loans for residential, commercial, and mixed-use projects nationwide. Our experienced team understands the complexities of construction financing and works to make the process as smooth as possible for developers, investors, and owner-builders.

This article is for informational purposes only and does not constitute financial advice. Loan terms, requirements, and availability are subject to change and vary by project and borrower qualifications.