How a commercial construction loan works: draws and inspections, interest during construction, converting to a permanent loan and building in Colorado.
A commercial construction loan funds building a new commercial property, or expanding an existing one, and releases the money in stages as the work is done.
You pay interest only on what has been drawn. When the building is finished, the loan converts to a permanent mortgage or is paid off by one. Construction is one stage of the commercial development process.
The lender is funding collateral that does not exist yet. That is why construction loans carry more checks, more equity and closer monitoring than a loan on a finished building.
What a Construction Loan Covers
A construction loan pays for an approved budget, split into hard costs, soft costs and contingency.
The Office of the Comptroller of the Currency (OCC) describes the categories this way:
| Budget category | What it includes |
|---|---|
| Hard costs | Site work, the building, general conditions, the contractor’s fee, bonds and contractor insurance |
| Soft costs | Interest, design, permits, fees and other development costs |
| Contingency | A reserve for unexpected overruns, usually 5% to 10% of the budget |
| Developer fee | Paid for managing the project; the OCC says it typically does not exceed 4% of project cost |
| Land | Often the borrower’s equity, if owned free and clear |
General conditions are the contractor’s site costs, such as trailers, dumpsters and cleanup. The OCC notes these are funded with each advance, not paid up front.
How Lenders Size a Construction Loan
Construction lenders size the loan on two tests: loan-to-cost (LTC) and loan-to-value (LTV) on the finished building.
Federal guidelines cap bank loans by stage. The interagency supervisory limits are:
| Loan category | Supervisory LTV limit |
|---|---|
| Raw land | 65% |
| Land development | 75% |
| Commercial, multifamily and other nonresidential construction | 80% |
| Improved (finished) property | 85% |
Most lenders set their own limits below these caps. Both value tests are explained in loan-to-value for commercial property.
Worked Example: Sizing the Loan
Assume a small industrial building in a Colorado town. All figures are illustrative.
| Item | Amount |
|---|---|
| Land (owned, contributed as equity) | $800,000 |
| Hard costs | $4,000,000 |
| Soft costs, including an interest reserve | $600,000 |
| Contingency | $300,000 |
| Total project cost | $5,700,000 |
- A lender offering 70% loan-to-cost: $5,700,000 × 70% = $3,990,000.
- Equity required: $5,700,000 − $3,990,000 = $1,710,000, including the $800,000 land.
- An appraiser values the finished building at $6,500,000.
- LTV on completion: $3,990,000 / $6,500,000 = about 61%, well under the 80% limit.
The lender lends the smaller of the LTC and LTV results. The development pro forma behind the budget is where these numbers start.
Equity Comes First
The OCC says a bank’s policy should require equity before construction loan disbursements begin. Cash, land bought with cash and up-front costs such as architect fees and permits usually count.
Deferred developer profit and unearned developer fees generally do not count as equity. The OCC also calls financing partial construction, without committed funds to finish, a liberal practice.
How Draws Work
A construction lender releases money in draws tied to stages of the work, after checking each stage.
Before the loan, the lender approves the plans, the cost estimate, an appraisal and the borrower’s finances. Before each draw, an inspection confirms that the previous stage is complete.
The OCC describes two common payment plans.
- Standard payment plan: fixed payments at set stages, normally used for homes and smaller commercial buildings.
- Progress payment plan: used for most commercial projects, with funds released as phases are completed.
A Draw Request, Step by Step
Under a progress payment plan, each draw follows the same cycle.
- The borrower submits a draw request by construction phase and cost category.
- The borrower certifies that the funds go to the project and that suppliers and subcontractors were paid.
- Lien waivers from subcontractors and suppliers come with the request.
- An inspector, often an architect or engineer, confirms the work on site.
- The title company updates the lender’s title policy to check for new liens.
- The lender funds the costs incurred, less a holdback.
The OCC says banks normally hold back 10% to 20% of each payment. This retainage covers overruns or unpaid bills.
Example: if $500,000 of completed work is approved with a 10% holdback, the lender funds $450,000 and holds $50,000.
The Final Draw
The final draw usually releases the holdback. Before paying it, the OCC lists three key controls:
- All lien waivers or releases from contractors, subcontractors and suppliers are in.
- A final inspection confirms the project is complete and meets specifications.
- The builder has a certificate of occupancy from the local building authority.
Interest and Payments During Construction
During construction, payments are usually interest-only and are charged only on the money drawn so far. On a $200,000 loan with $50,000 drawn, for example, interest is charged on the $50,000.
Most construction loans float over an index such as SOFR or prime. SOFR was 3.94% and prime 7.00% in late October 2026, per FRED. How lenders add the spread is covered in how commercial loan rates are priced.
The Interest Reserve
An interest reserve is a line in the construction budget that pays the loan’s interest until the building earns income. The OCC says it should cover interest through completion and lease-up, sale or occupancy.
A rough estimate multiplies the expected average balance by the rate and the months of construction and lease-up. With an average balance of $2,000,000, an 8% rate and 18 months, the reserve would be about $240,000. These inputs are illustrative.
The OCC warns that a depleted reserve usually means the borrower or guarantor must add cash. Refilling the reserve with more debt is a red flag for the lender.
Construction Loan Risks and Protections
The OCC lists the main risks in construction lending:
- Cost overruns from bad budgets, material price jumps, labor shortages, soil problems or weather delays.
- A contractor or subcontractor failing to finish, or finishing below specification.
- Liens filed by unpaid contractors and suppliers.
- Delays from labor disputes or late materials.
- Diverted draw funds and loan administration errors.
Lenders and borrowers use several tools against them.
| Protection | What it does |
|---|---|
| Fixed-price contract | Moves cost overrun risk to the contractor |
| Guaranteed maximum price | Used when the borrower and contractor are related |
| Payment bond | Ensures subcontractors and suppliers get paid |
| Performance bond | Ensures the work gets finished |
| Title insurance and date-downs | Protect against construction liens |
| Completion guarantee | Makes a sponsor responsible for finishing the building |
| Preleasing requirement | Proves tenant demand before or during construction |
The OCC also warns about front loading. That is when a builder overstates early-stage costs, leaving too little money to finish if something goes wrong.
Why Banks Price Construction Loans Higher
Bank capital rules treat many construction loans as high-risk. Under the federal rule effective April 1, 2020, a “high volatility commercial real estate” (HVCRE) loan without an exclusion carries a 150% risk weight.
A higher risk weight means the bank must hold more capital against the loan. That cost shows up in pricing, equity requirements or both.
After Construction: Converting or Refinancing
A construction-to-permanent loan turns into a regular mortgage when the building is done, while a construction-only loan must be paid off with new financing.
SBA 504 loans can also fund new construction for an owner-occupied building. See refinancing after construction.
The OCC describes two kinds of takeout commitments that construction lenders look for:
- Standby commitment: back-up permanent financing if the borrower cannot find better terms. Its fees and rate are often set to discourage use.
- Forward commitment: a lender, often a life insurance company, agrees to fund the permanent loan after completion and lease-up. The rate is often locked in advance.
Both usually require the building to be finished and leased to a set level. A building that is complete but not yet leased may need a short-term bridge to stabilization before the permanent loan.
Owner-users who plan to occupy the building should compare SBA 504 construction financing in Colorado with a bank construction loan.
Building in Colorado
Mountain construction costs and limited land shape every Colorado project.
RMCRE members model mountain construction costs in their feasibility work. In Durango, new industrial building works for owner-users but is hard for speculative developers. Start with building a development pro forma.
Colorado Mechanics’ Liens and the Construction Lender
Colorado mechanics’ liens can outrank later loans, so every draw is checked for them. Under C.R.S. 38-22-106, these liens relate back to the time work began on the project.
Key Colorado deadlines under C.R.S. 38-22-109:
| Step | Deadline |
|---|---|
| Notice of intent to file a lien | Served on the owner and prime contractor at least 10 days before filing |
| Lien statement, most claimants | Within four months after the claimant’s last labor or materials |
| Lien statement, day or piece laborers only | Within two months after the building is completed |
| Notice to extend | Extends filing to four months after completion; ends six months after filing |
This is why the lender’s title policy is updated with each draw. The OCC notes that where mechanics’ liens can take priority, updating the title policy with each draw is important. A Colorado real estate attorney should review lien waivers and priority on any large project.
Local Rules That Affect Cost and Timing
Local codes change budgets and schedules across the state:
- Colorado Springs: RMCRE’s Q2 2026 report notes the Wildland Urban Interface ordinance revised fire-resistance rules for building in wildfire-prone areas.
- Grand Junction: the city delayed enforcing a new irrigation design certification requirement until January 1, 2029, per RMCRE’s Mesa County Q2 2026 update.
- Pagosa Springs: new light industrial and flex construction continues to add inventory, per RMCRE’s Q1 2026 report.
- Durango: RMCRE’s 2026 outlook notes minimal speculative office construction and land costs and zoning limits on new industrial.
Lenders also watch the national picture. In the Fed’s July 2026 Senior Loan Officer Survey, construction loan standards were basically unchanged and a moderate net share of banks reported weaker demand.
Mistakes to Avoid
- A thin contingency: mountain sites hide soil, access and weather problems.
- An interest reserve sized for the best case: delays and slow leasing drain it.
- Deferring equity: lenders expect equity in before the first draw.
- Weak lien paperwork: missing waivers can hold up a draw or the final payment.
- No takeout plan: the permanent loan must work at the rates expected at completion.
- Change orders without approval: the OCC notes lenders should review and approve plan changes.
Frequently Asked Questions
How much down payment does a commercial construction loan need?
Construction lenders usually require equity equal to a meaningful share of total project cost, and it must go in before draws begin. Federal guidelines cap bank construction loans at 80% of value for commercial projects, and most lenders lend less. Land owned free and clear often counts toward the equity.
How are construction loan draws paid?
The borrower submits a draw request with lien waivers, an inspector confirms the work and the title is updated. The lender then funds the completed work, less a holdback. The OCC says holdbacks are normally 10% to 20% of each payment.
Do you pay interest on the full construction loan?
No, interest is charged only on the amount drawn so far. Payments are usually interest-only during construction. Many projects fund that interest from an interest reserve in the budget.
What happens when the construction loan matures?
A construction-to-permanent loan converts to a regular mortgage. A construction-only loan must be repaid, usually by a permanent loan, a bridge loan or a sale. Lenders often want a takeout commitment in place.
Can an SBA loan be used for construction?
Yes, SBA 504 loans can fund new construction of an owner-occupied building. The business must occupy the property. Investment property built for tenants usually needs a conventional construction loan.
Construction and SBA Lenders in the Network
Several RMCRE affiliates work specifically in construction and SBA lending. Learn about RMCRE development services.
Rocky Mountain Commercial Real Estate is a network of partner brokers across Colorado mountain towns, active since 2010. We help owners and developers find sites, test feasibility and connect with construction lenders. For a site search, start with Colorado commercial land listings.
