Construction Loan Glossary

Essential terms and definitions for construction financing

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Understanding Construction Loan Terminology

Navigating construction financing can be complex, with specialized terminology that may be unfamiliar to first-time builders. This comprehensive glossary explains key terms you'll encounter during your construction loan journey, from initial application through project completion and permanent financing conversion.

Understanding these terms will help you communicate effectively with lenders, contractors, and other professionals involved in your construction project. Whether you're planning a custom home build, major renovation, or investment property construction, this glossary serves as your reference guide throughout the process.

Pro Tip: Bookmark this page for quick reference during lender meetings and contractor discussions. Understanding these terms can help you negotiate better rates and avoid costly misunderstandings.

A

Appraisal

A professional evaluation of your construction project's expected value upon completion. Lenders require appraisals to ensure the loan amount is appropriate for the projected property value.

B

Builder's Risk Insurance

Specialized insurance that protects the structure during construction from damage due to fire, weather, theft, or vandalism. Most lenders require this coverage.

Building Permit

Official approval from local government to begin construction. Permits ensure your project meets building codes, zoning laws, and safety regulations.

C

Certificate of Occupancy (CO)

Document issued by local authorities confirming the building is safe for occupancy and meets all codes. Required before converting to permanent financing.

Change Order

Written authorization to modify the original construction plans or specifications. Change orders typically affect project cost and timeline.

Construction Draw

Scheduled disbursement of loan funds based on construction progress. Draws typically occur at major milestones like foundation completion, framing, and final inspection.

Construction-Only Loan

Short-term financing that covers only the construction phase. Requires separate permanent financing application after construction completion.

Construction-to-Permanent Loan

Single loan that covers both construction and permanent financing phases, converting automatically from construction loan to mortgage upon completion.

Contingency Reserve

Additional funds (typically 10-20% of budget) set aside for unexpected costs or overruns during construction. Many lenders require contingency reserves.

Cost-Plus Contract

Construction agreement where the owner pays actual costs plus a contractor fee. Provides transparency but less cost certainty than fixed-price contracts.

D

Draw Schedule

Timeline outlining when construction loan funds will be disbursed. Typically tied to completion of specific construction milestones.

F

Fixed-Price Contract

Construction agreement with a set total price for the entire project. Provides cost certainty but may include higher contingency amounts.

Float-Down Option

Feature allowing borrowers to lower their locked interest rate if rates decrease before closing. Usually involves additional fees.

G

General Contractor (GC)

Licensed professional who manages the entire construction project, coordinating subcontractors, materials, permits, and inspections.

H

Hard Costs

Direct construction expenses including labor, materials, and equipment. These are the physical costs of building the structure.

I

Interest Reserve

Funds set aside to cover interest payments during construction. May be included in the loan amount to avoid out-of-pocket interest payments.

L

Lien Waiver

Document from contractors and suppliers confirming payment received and waiving rights to file a mechanic's lien against the property.

Loan-to-Cost (LTC) Ratio

Percentage comparing loan amount to total project cost. Most construction loans have LTC ratios of 70-80%, requiring 20-30% down payment.

Loan-to-Value (LTV) Ratio

Percentage comparing loan amount to appraised property value upon completion. Lower LTV ratios typically qualify for better interest rates.

M

Mechanic's Lien

Legal claim against property by unpaid contractors or suppliers. Can complicate property sale or refinancing if not resolved.

O

One-Time Close Loan

Another term for construction-to-permanent loan, requiring only one closing for both construction and permanent financing phases.

Owner-Builder

Homeowner acting as their own general contractor. Some lenders allow owner-builders but typically require construction experience and higher down payments.

P

Performance Bond

Insurance guaranteeing contractor will complete the project according to contract terms. May be required for larger projects.

Permanent Financing

Long-term mortgage that replaces the construction loan once building is complete. Typically a 15-30 year conventional mortgage.

Plans and Specifications

Detailed architectural drawings and written specifications describing materials, finishes, and construction methods. Required for loan approval.

Progress Inspection

Lender-ordered inspection to verify construction progress before releasing draw funds. Ensures work is completed to specifications.

Punch List

List of minor items to complete or correct before final inspection and project completion. Common at end of construction.

R

Rate Lock

Agreement guaranteeing a specific interest rate for a set period. Protects against rate increases during construction.

S

Soft Costs

Indirect construction expenses including permits, architectural fees, legal costs, and loan fees. Not directly related to physical construction.

Spec Home

Speculative home built without a specific buyer, intended for sale upon completion. May have different financing requirements.

Subcontractor

Specialized tradesperson hired by general contractor for specific work like plumbing, electrical, or roofing.

T

Take-Out Loan

Permanent mortgage that "takes out" or replaces the construction loan upon project completion.

Title Insurance

Protection against losses from disputes over property ownership. Required by lenders to protect their investment.

Two-Time Close Loan

Financing structure requiring separate closings for construction loan and permanent mortgage, with two sets of closing costs.

V

Variance

Official permission to deviate from zoning regulations or building codes. May be needed for unique construction projects.

Voucher System

Payment method where lender pays contractors directly after approving invoices, ensuring proper use of loan funds.

W

Working Capital

Funds needed to cover expenses between construction draws. Contractors often need working capital to purchase materials before draws.