Construction Lending Explained: Draw Schedules, Interest Reserves, and Retainage
By Zolvo · 6 min read
Construction lending is the most operationally intensive product in commercial real estate finance. Unlike a loan against a finished, income-producing building, a construction loan funds an asset that does not yet exist and produces no revenue while it is being built. The lender is underwriting a plan and a budget as much as a property, and it releases money in stages against verified progress rather than in a single advance at closing. That draw-based structure, and the monitoring it demands, is what makes construction lending distinct, and what makes it hard to service well.
Why construction loans are structured differently
A construction loan carries risks a permanent loan does not. The collateral is incomplete for the entire loan term, so if the project stalls the lender is left holding a half-finished building worth far less than its projected value. There is no income to service the debt during the build. Costs can overrun, contractors can fail, and the finished value depends on a market that may have moved by the time the project delivers. To manage this, lenders do not hand over the full loan at closing. They commit the total but release it incrementally, funding the project as it is built and verified.
This is why a construction loan is best understood as a bridge to a permanent outcome. It funds the build, and at completion it is repaid either by a sale or by refinancing into permanent debt, often the same distinction that separates a bridge loan from a conventional loan: the construction loan is short-term and transitional, and the permanent loan takes over once the asset is stabilized.
How the draw process works
The heart of a construction loan is the draw schedule. The loan is divided into a series of advances tied to construction milestones, foundation, framing, roofing, mechanicals, finishes, and the borrower requests each draw as that stage is completed. Before releasing funds, the lender verifies the work, typically through an inspection by an engineer or the lender's own construction consultant, confirming that the completed work matches the draw request and the budget line items.
Two mechanisms protect the lender inside this process. The first is retainage, a percentage of each draw held back until the project is complete, which gives the contractor an incentive to finish and gives the lender a cushion if the job has to be completed by someone else. The second is the requirement that the borrower's own equity usually goes in first, so the lender is not exposed until the owner has real money at risk. Every draw is checked against the budget, and lien waivers from subcontractors are collected to ensure the funds released actually paid for the work and did not leave mechanics liens behind that could jump ahead of the lender.
The interest reserve
Because a project under construction generates no income, the borrower has no cash flow to make interest payments during the build. Construction loans solve this with an interest reserve, a portion of the loan proceeds set aside at closing specifically to cover interest as it accrues. The lender effectively lends the borrower the money to pay itself interest until the property is complete and can carry its own debt service.
The interest reserve has to be sized carefully. If the project runs long, which construction projects routinely do, the reserve can be exhausted before the building is finished and producing income, forcing the borrower to fund interest out of pocket at the worst possible moment. Monitoring how fast the reserve is being drawn relative to construction progress is one of the clearest early-warning signals a construction lender has.
Sizing and securing the loan
Construction loans are sized against cost and value together. Lenders look at loan-to-cost, the loan as a share of the total project budget, alongside loan-to-value measured against the projected completed value, and lend to the more conservative of the two. Underwriting the finished value also means testing whether the completed property will support permanent debt, which is where a projected debt service coverage ratio comes in; our DSCR calculator models whether the stabilized income will cover the take-out loan, and the CRE loan sizing calculator tests the exit against value, coverage, and debt yield.
The lender perfects its position with a recorded mortgage on the real estate and a UCC filing on related personal property, and on most projects requires a personal guarantee, frequently including a completion guarantee that puts the sponsor on the hook to finish the project. Once the loan converts to permanent financing, repayment shifts to normal amortization against the now-income-producing asset.
Why servicing is the hard part
Originating a construction loan is a underwriting exercise; servicing one is a continuous operation. Over a build that can run 12 to 36 months, the lender has to process and inspect every draw, track the budget line by line against actual spend, collect and verify lien waivers, monitor the interest reserve burn, watch the construction timeline against milestones, and confirm the project is still on track to a value that supports the exit. A missed lien waiver, an over-funded draw, or an interest reserve running dry can each turn a performing loan into a loss.
At portfolio scale, across many projects each on its own timeline with its own draw cadence and inspection cycle, this becomes an enormous operational load that punishes any lapse. It is the same servicing discipline that underpins every secured lending product, concentrated into a product where the collateral is literally being built in real time. For how a loan is handled once the warning signs appear, see our guide on the distressed commercial loan lifecycle, and for how CRE loans are sized and serviced once complete, commercial real estate lending explained.
Frequently asked questions
How is a construction loan different from a regular mortgage?
A regular mortgage funds a finished, income-producing property in a single advance and is repaid from the property's cash flow. A construction loan funds a property that does not yet exist, releases money in stages against verified progress, carries no income to service the debt during the build, and is repaid at completion by a sale or by refinancing into permanent financing. It is transitional debt, not long-term debt.
What is a draw schedule?
A draw schedule divides a construction loan into a series of advances tied to construction milestones such as foundation, framing, and finishes. The borrower requests each draw as that stage is completed, and the lender verifies the work through an inspection before releasing funds, checking that completed work matches the request and the budget. This staged funding limits the lender's exposure to work that has actually been built.
What is an interest reserve and why do construction loans need one?
An interest reserve is a portion of the loan proceeds set aside at closing to pay interest during construction, when the project generates no income to cover it. The lender effectively funds the borrower's interest payments until the property is complete. If the project runs long, the reserve can be exhausted before completion, forcing the borrower to pay interest out of pocket, which is why monitoring reserve burn against progress is critical.
What is retainage in construction lending?
Retainage is a percentage of each draw the lender holds back until the project is complete. It gives contractors an incentive to finish the job and gives the lender a cushion to complete the work if the contractor fails. Combined with lien waivers collected at each draw, retainage protects the lender against unfinished work and against subcontractor claims that could take priority over its lien.