Construction loans differ from regular commercial mortgages in two big ways: the money is disbursed in stages tied to physical progress, not a single closing wire, and they typically convert to permanent financing at completion (or are paid off by a separate take-out loan). Owners who treat them like conventional mortgages get into trouble fast.
How draws work
Construction loans fund progressively. The borrower submits a draw request after each completed phase (foundation, framing, mechanical rough-in, etc.). The lender sends an inspector to verify completion against the approved budget, and only then funds the draw.
Most construction loans require a contingency reserve of 5%–15% of total project cost to cover overruns. Going over budget without a documented change order typically delays draws.
Interest-only during construction
During the construction phase, borrowers usually pay interest only on the funded balance, not on the total approved loan. As more draws fund, the interest payment grows. Budgeting for the increasing interest payment is essential — many borrowers underestimate this cost.
Take-out and conversion
At completion (and certificate of occupancy issuance), the construction loan either converts to a permanent mortgage (a "construction-to-perm" loan, common with SBA 504) or is paid off by a separate permanent loan from a different lender. Construction-to-perm avoids a second closing; separate take-outs allow the borrower to shop the permanent loan but introduce timing risk.
Common pitfalls
Choosing the lowest-bid contractor without verifying licensing, insurance, and bonding. Underestimating soft costs (architects, permits, surveys, inspections, insurance, interest reserve). Failing to lock in a take-out commitment before construction starts. Material changes to the scope mid-project without renegotiating the budget.
Sources
Editorial note: This article is general information about how small-business lending products work. It is not financial, legal, or tax advice for any specific borrower. Loan terms, eligibility, and rates vary by lender, borrower profile, and current market conditions, and the specific facts of your business will determine which products and structures actually fit. Consult a CPA, attorney, or SBA-approved lender before making decisions that affect your business.