Construction Loans: How They Work and How to Qualify

Planning a build? Talk to Herring Bank’s construction lending team about a One-Time Close loan. Herring Bank · NMLS #415783 · Equal Housing Lender

How Construction Loans Work

A purchase mortgage is funded in one go: the lender wires the full loan amount to the title company, and the seller is paid. A construction loan is funded in pieces because the collateral, the finished house, is being built as you go. The lender sets the full loan amount at closing from your contract price and the appraiser’s estimate of the value once complete, then holds those funds and releases them as the builder hits milestones.

A typical build moves through four stages:

1. Closing. You sign the loan documents. If you are buying the lot, the lot purchase is paid at closing. Closing costs are paid or financed, and any reserve accounts are set up.
2. Construction and draws. The builder requests money for completed phases (foundation, framing, dry-in, mechanicals, finishes). The lender inspects, then pays. You make monthly interest-only payments on the balance drawn so far.
3. Completion. Final inspection, lien releases, certificate of occupancy where required, and proof of homeowner’s insurance.
4. Conversion. The loan becomes a fully amortizing mortgage (principal and interest), with escrow for taxes and insurance.

Herring Bank’s own process follows this pattern. Its One-Time Close construction loan guide explains that the loan amount covers the funds to build, the lot purchase if applicable and closing costs if applicable, and that interest invoices reflect only “construction funds used as of the last day of the previous month.”

One-Time Close vs. Two-Time Close Construction Loans

There are two ways to structure construction financing. The difference is how many times you close, and who carries the risk of rates and qualification changing during the build.

Under Fannie Mae’s Selling Guide (B5-3.1-02), a single-close loan can be a purchase, where the construction loan also buys the lot, or a limited cash-out refinance, where you already own the lot. Cash-out is not allowed. When the home is done, only four terms may be modified: interest rate, loan amount, loan term and amortization type (adjustable to fixed only). Any other change requires a two-time close. A loan amount increase is only allowed to cover documented increases in construction cost.

At Herring, conversion happens without a second closing. The modification documents are signed at your local Herring Bank mortgage center. You will lock the permanent rate if you haven’t already, and if you locked during construction, you can ask your loan officer whether a float-down to the current market rate is available.

Construction Loan Requirements

Construction loan requirements are stricter than for a resale purchase because the lender is financing a plan, not a finished house. Expect underwriting in three areas.

1. You: credit, income, cash

• Credit score. For conventional loans, Fannie Mae no longer sets a fixed minimum score for loans run through Desktop Underwriter (B3-5.1-01). Manually underwritten fixed-rate loans need 620. Lenders add their own construction overlays, so ask before you apply.
• Debt-to-income. You qualify on the full permanent payment (principal, interest, taxes, insurance, mortgage insurance and HOA), not on the smaller interest-only payment during the build.
• Down payment. Fannie Mae applies its ordinary purchase LTV limits to single-close loans, and LTV is measured against the lower of total cost (lot plus construction) or the as-completed appraised value. If your LTV is 80% or lower, gift funds can cover the whole down payment. Above 80%, the usual borrower-contribution rules apply. Lenders often ask for more down on construction than on a resale. Herring’s One-Time Close goes up to 80% LTV, so plan on at least 20% down.
• Cash beyond the down payment. Change orders that push the cost above the loan amount are paid from your own pocket. Herring’s guide states plainly that “the loan amount cannot be increased to cover change orders.”

2. Your builder

The lender is relying on your builder to finish the house on budget. Expect a builder approval step that usually checks licensing or registration where it applies, general liability and builder’s risk insurance, references and recent completed projects, and sometimes financial statements. Herring requires Builder’s Risk Insurance to stay in force throughout construction.

3. The project

• Signed construction contract with a fixed price or a cost-plus contract with a cap
• Plans and specifications
• Line-item cost breakdown (Herring uses its own Cost Breakdown Form)
• Survey and, for rural lots, well and septic plans or permits
• A subject-to-completion appraisal, where the appraiser values the home “as completed” from the plans. This value caps your loan.

The Draw Process, Step by Step

The draw schedule is where construction loans differ most from a regular mortgage. Here is how Herring Bank describes its draw process:

1. Builder requests a draw for completed work only, not work in progress, on two forms: a Draw Request Form and an All Bills Paid Affidavit stating the funds will pay all labor and material for that draw.
2. Inspection. Herring’s draw specialist orders a property inspection.
3. Funding. The amount released is based on the percentage complete for the line items requested. You can authorize payment directly to the builder by wire.
4. Timing. Draws take an average of 72 hours. Inspection delays can slow this, and if your interest payment is past due (after the 15th), the draw may be held until it is paid.
5. Final draw. Usually the last 10% of the contract. It is released once completion is verified and may take longer than 72 hours.

Before the final draw, Herring may require:

• A date-down endorsement from the title company confirming no new liens were filed during construction
• A final survey
• The builder’s notarized Final Lien Waiver and your signed Affidavit of Completion
• A Final Inspection (Form 442) and recertification of value by the original appraiser
• A certificate of occupancy, plus well or septic certification if your city or county requires them
• Evidence of a homeowner’s insurance policy paid one year in advance, in place before you move in

Interest, Reserves and Costs During the Build

During construction you make interest-only payments on the money drawn so far. Herring’s first interest payment is due 30 days from the note date, then every 30 days, with invoices mailed 10 to 15 days before each due date. Property taxes and insurance that come due during construction are your responsibility.

Worked example: a $440,000 build near Amarillo

Assumptions are illustrative, not a rate quote: lot $60,000, construction contract $380,000, total cost $440,000, as-completed appraisal $460,000, 20% down ($88,000, which covers the $60,000 lot and the first $28,000 of construction), loan amount $352,000 (80% of total cost), construction interest 7.00%, permanent rate 6.50%, 30-year fixed.

Total construction interest over nine months is about $9,110, far less than nine full mortgage payments because the balance builds up gradually. After conversion, principal and interest on $352,000 at 6.50% is about $2,225 a month. Add Texas property taxes, which run near 2% of value in many Panhandle taxing districts (about $767 a month on $460,000), and homeowner’s insurance (about $300 a month in this example). At 80% LTV, the loan doesn’t need private mortgage insurance. Your actual tax rate depends on your appraisal district and the taxing units that apply. Check your own numbers with Herring’s mortgage payment calculator.

Reserve accounts

• Modification Reserve Account. Holds funds for future escrow items such as taxes, insurance and mortgage insurance, since escrow can’t be set up until conversion. No interest is charged on it until it is used.
• Borrower’s Contingency Reserve. Extra financed funds above the contract for overruns or upgrades. The builder can only use it with your written approval.
• Unused reserves are applied as a principal reduction when the loan is modified.

At modification, expect to pay construction interest through signing, prepaid interest on the permanent loan, the escrow setup and any shortage in inspection fees.

Ready to price your build? Start your construction loan application with Herring Bank and a loan officer will review your lot, plans and builder with you. NMLS #415783 · Equal Housing Lender

Financing Land and Construction in One Loan

A land and construction loan in a single closing is often the cleanest approach. Under Fannie Mae rules:

• If you are buying the lot with the construction loan, the deal is a purchase and LTV is based on the lower of lot price plus construction cost, or the as-completed value.
• If you already own the lot before the first construction advance, the deal is a limited cash-out refinance. The loan pays off any lot lien and funds the build, and LTV is based on the as-completed appraised value. Equity in a lot you own outright can carry some or all of the down payment, because the value of the land is part of that appraisal.

Buying raw or rural acreage now and building in a few years? Read our guide to Texas land loans, and for larger acreage with improvements, see Texas ranch loans. If you need to buy before you have sold your current home, a bridge loan can cover the gap.

Using Conventional, FHA, VA or Jumbo Financing to Build

Which of these Herring’s One-Time Close supports depends on the program. Herring offers conventional home loans and jumbo loans for purchases, and a loan officer can tell you which build programs are available for your lot and price point.

Building in Texas: Builder Vetting, Mechanic’s Liens and Homestead

Texas has some of the most detailed construction lien rules in the country, and they explain much of the paperwork your lender requires.

Mechanic’s and materialman’s liens (Property Code ch. 53)

• Retainage. Owners must hold back 10% of the contract price (or of the value of work done) during construction and for 30 days after completion (§53.101). This is one reason the final draw is about 10%.
• Bills-paid affidavits. Anyone who supplies labor or materials must, on request and as a condition of payment, sign an affidavit that subcontractors and suppliers have been paid, or list who is still owed (§53.085). Herring’s All Bills Paid Affidavit at each draw puts this into practice.
• Filing deadlines. On residential projects, an unpaid contractor or supplier generally has until the 15th day of the third month after its work ends to file a lien affidavit (§53.052). That is why lenders order a date-down title check before the final draw.
• Disclosure. Before you sign a residential construction contract, the builder must give you the “Know Your Rights and Responsibilities” disclosure statement (§53.255).

Building on your homestead

The Texas Constitution allows a lien on a homestead for “work and material used in constructing new improvements” only if it is contracted for in writing (Art. XVI, §50(a)(5)). Under Property Code §53.254, the contract must be signed before any work begins or material is delivered. It must be signed by both spouses if you are married, and it must be filed with the county clerk. If you own the lot and live on it, or will claim it as your homestead, expect your lender and title company to manage these signatures carefully at closing. Once you move in, file for the homestead exemption. Our guide to the Texas homestead exemption explains how.

Builder vetting checklist

• Verify insurance certificates (general liability, workers’ compensation where applicable, builder’s risk).
• Visit two finished homes and one active job site.
• Ask how the builder handles change orders and allowances, and get allowances in writing.
• Confirm who pulls permits, and whether the county requires septic (OSSF) permits through TCEQ or a local authorized agent.
• Check for recorded lien affidavits against the builder’s past projects at the county clerk.

If problems arise with your builder, subcontractors or suppliers during the build, Herring asks you to notify the bank right away.