Construction Loan: Templates & More

A construction loan agreement is a legal document that sets out the terms and conditions for a loan made by a lender to a borrower to finance the construction of a building, whether a commercial property, a multifamily project or a custom home. Unlike a standard mortgage, the funds are not paid out at closing. The lender advances the loan in draws as construction progresses, charges interest only on the amount advanced, and expects the loan to be repaid or converted to permanent financing when the building is complete.

The agreement includes the loan amount, interest rate, repayment terms and collateral, together with the conditions the borrower must meet to receive each advance. The borrower is required to provide regular updates and reports on the progress of the project, and the lender inspects the work before funding each draw.

How a construction loan works

1. Budget and plans: the lender approves the construction budget, the plans and specifications, the general contractor and the construction contract before closing. The loan is sized to a loan-to-cost ratio, commonly 70 to 85 percent of total project cost, with the borrower funding its equity first.
2. Draw schedule: funds are advanced monthly or at completion of defined stages (foundation, framing, rough-in, finish). Each draw request includes the contractor's application for payment, invoices, and lien waivers from the contractor and subcontractors for the prior draw.
3. Inspection and title update: the lender's inspector or architect confirms the percentage of work completed, and the title company updates the title to confirm no mechanic's liens have been recorded, before each advance.
4. Retainage: the lender holds back a portion of each draw, typically 5 to 10 percent, until the project is complete and the final lien waivers are delivered.
5. Interest reserve: interest on the drawn balance is usually paid from a reserve built into the loan, so the borrower makes no cash payments until completion.
6. Term and maturity: construction loans run 12 to 36 months depending on the project. At maturity the borrower pays the loan off by selling the property, refinancing with a permanent loan, or, under a construction-to-permanent loan, converting the same loan to a long-term mortgage.

Key clauses

• Conditions precedent to each advance, including the required lien waivers, inspection reports and evidence that the remaining loan funds are enough to finish the project (the "in balance" test). If costs rise, the borrower must deposit the shortfall before the next draw.
• Completion date and completion guaranty: the borrower, and usually its principals, guarantee that the project will be finished lien-free by a set date, in addition to any payment guaranty.
• Change orders: changes above a dollar threshold require the lender's consent.
• Insurance: builder's risk insurance covering the structure during construction, general liability, and workers' compensation, with the lender named as mortgagee and additional insured.
• Assignment of plans, permits and the construction contract to the lender, so it can finish the project if it takes over after a default.
• Defaults specific to construction: stopping work for more than a set number of days, a mechanic's lien that is not bonded or released, loss of a permit, or a contractor's insolvency.
• Conversion terms, for construction-to-permanent loans, stating the rate, amortization and conditions for the permanent phase.

Residential construction loans

For an owner-occupied home, a construction loan is a consumer credit transaction subject to the Truth in Lending Act and the TRID disclosure rules, and lenders use either a two-closing structure (a construction loan followed by a separate permanent mortgage) or a single-close construction-to-permanent loan. The borrower usually needs a licensed builder, a fixed-price contract and a larger down payment than a purchase mortgage requires, and the lender's inspections and draw process follow the same pattern as a commercial loan.