Construction loans: How draws, interest-only periods and payments work

A construction loan calculator has to do a job no ordinary loan calculator does, because a construction loan is not really one loan — it is two. For about a year you borrow in slices, pay interest only, and owe nothing toward principal; then the whole balance converts into a regular mortgage with regular payments. I will walk through a complete $400,000 build at an 8% construction rate — every draw, every interest-only payment, and the exact month the loan turns into a $2,661.21 mortgage payment — so you can see where the money goes in each phase.

How a construction loan actually works

The lender does not hand you $400,000 and wish you luck. Before closing, you agree a total budget and a draw schedule tied to building stages. The builder completes a stage, an inspector verifies the work, and only then does the lender release that stage’s money — a draw. Three consequences follow:

• You pay interest only on what has been drawn. Undrawn money costs you nothing. This is the single most borrower-friendly feature of the structure.
• Payments during the build are interest-only. The balance never falls during construction; it only grows, draw by draw, until it reaches the full loan amount.
• The rate is usually higher than a finished-home mortgage rate, and the term is short — commonly 12 months, sometimes extended to 18 or 24 for larger projects.

Lenders also underwrite construction loans more strictly than standard mortgages: detailed plans and a licensed builder are normally required, and a down payment of 20% to 25% is common, though land you already own can count toward that equity. When the build finishes, the loan either converts into a permanent mortgage under the same closing (a construction-to-permanent loan) or is paid off by a new mortgage you arrange separately.

The draw schedule: a $400,000 build at 8%

Here is our example build, with draws landing at the start of each stage and interest billed monthly on the drawn balance at 8% (balance × 8% ÷ 12):

Interest-only payments on a staged $400,000 construction loan at 8%. Each payment is the drawn balance times 8% divided by 12; no principal is repaid during the build.

Add the twelve payments up and the construction phase costs $20,000.00 in interest, an average of $1,666.67 a month. Now the counterfactual that shows why draws matter: if the full $400,000 had been borrowed on day one, the same year at the same rate would have cost $32,000. The draw structure saves $12,000 — you only ever pay interest on work that is actually in the ground. It also means the true cost of the finished house in this example is $420,000 before the mortgage even starts: $400,000 of build plus $20,000 of construction interest.

Conversion day: what the payment becomes

At the end of month 12 the full $400,000 is drawn and the interest-only period ends. Rolled into a permanent mortgage at 7% over 30 years, the payment becomes $2,661.21 a month, and the first payment splits $2,333.33 to interest and just $327.88 to principal. Over the 30 years that mortgage adds $558,035.91 of interest of its own. A 15-year conversion at the same rate would cost $3,595.31 a month but only $247,156.90 of interest — worth pricing both ways in a mortgage calculator before you commit.

My favorite detail in this whole example: the last interest-only payment, $2,666.67, is actually $5.46 higher than the permanent mortgage payment that replaces it. That feels wrong until you see why — the construction phase charges a higher rate (8% versus 7%) on the full balance, while the mortgage payment spreads a slightly lower rate across principal and interest combined. Do not assume conversion day brings payment shock; on these numbers it brings a small relief.

One closing or two?

There are two ways to structure the conversion, and the choice is made before the first draw. A construction-to-permanent loan closes once: you sign a single set of documents, pay one set of closing costs, and the loan automatically becomes the permanent mortgage when the build is certified complete. Its weakness is that the permanent terms are set by the same lender up front. A standalone construction loan covers only the build; when it matures you arrange the permanent mortgage separately, pay a second set of closing costs, and accept whatever rates the market offers that month — better if rates fall, painful if they rise, and it leaves you exposed if your finances change mid-build and the permanent loan is refused. For most owner-builders I see, the single closing is worth the slightly less flexible terms.

The costs outside the draw table

The $20,000 of interest is the biggest construction cost, but not the only one the draw table hides:

• Draw and inspection fees. Each draw follows an inspection, and many lenders charge a fee for every one. Six draws at even a modest fee adds up across a year-long build.
• A contingency reserve. Lenders often require a reserve — frequently around 10% of the build budget — held back for cost overruns. It is your money, but it is not available to spend freely.
• Double housing costs. Unless you can live on site, you are paying rent or an existing mortgage in parallel with the interest-only payments for the whole build.
• Delay interest. The schedule above assumes the build finishes on time. Two extra months at full draw add 2 × $2,666.67 = $5,333.34 of interest — priced in advance, that is the contingency I mentioned earlier.

Running your own construction numbers

You do not need special software for the build phase: a construction loan calculator is really a draw table plus one formula, drawn balance × rate ÷ 12. Sketch your stages, multiply each stage’s balance by your rate, and you have the interest-only payments and the construction interest total. The permanent phase is the opposite — it is a standard amortizing loan, so that is where a loan calculator earns its keep: run the converted balance at two or three rates and terms and compare the total interest, not just the payment.

Sources: Consumer Financial Protection Bureau (CFPB) consumer guidance on construction loans and loan estimates; draw schedule, interest-only payments and mortgage figures computed cent by cent for this article. Rates and down-payment norms are illustrative — your lender’s terms will differ.