Interest only on this month's draw? How construction loan interest is really calculated

The question was posted on r/Homebuilding. According to the post, the loan officer explained that interest on the 7% construction loan would be charged on the current month's draw alone, not on the running balance. On a $600,000 budget, the couple worked out about $4,000 of interest during the build instead of $20,000 or more.

Standard draw loans do not work that way. Regulation Z, the federal Truth in Lending rule, describes the usual construction loan as one where interest accrues on the money the lender has actually paid out, for as long as that money stays out. A draw funded in month two is still costing interest in month ten. When a lender has to estimate construction interest for its disclosures, Appendix D tells it to assume half the full loan amount is outstanding for the entire build.

Apply that to the couple's loan. Half of $600,000 at 7% for 12 months is about $21,000. Groundbase, a home-building budget software company, puts the monthly bill on the same loan at about $583 after the first $100,000 is drawn and about $3,500 once all of it is out. The $4,000 figure would only hold if each draw stopped accruing a month after it was funded.

Before closing, read the interest clause in the promissory note itself, since a loan officer's email is not the contract. It should say whether interest is charged on the outstanding principal, how often it is billed, and whether it is paid from an interest reserve. Under the Regulation Z commentary, interest taken from a reserve inside the loan also accrues interest. Budget the carrying cost as its own line, and add a month of it for every month the build may run late.