Why Construction Loans Operate Without a Traditional Escrow Account

When it comes to financing a construction project, many consumers wonder whether an escrow account is involved, similar to traditional mortgage loans. The answer is not straightforward, as construction loans operate differently.

Is There an Escrow Account?

Typically, construction loans do not have a traditional escrow account like a standard mortgage. In a traditional mortgage, an escrow account is used to hold funds for property taxes and homeowners’ insurance, which the lender disburses on the borrower’s behalf. However, construction loans function on a draw schedule system, not an escrow model.

Why Not?

The reason construction loans lack an escrow account is due to the nature of the loan itself. The loan funds are not provided in a lump sum. Instead, they are released in phases, known as “draws,” as construction milestones are completed. The lender monitors the progress of the project and releases funds accordingly to ensure that the money is being used as intended and that the project is progressing as planned.

Additionally, taxes and insurance are often the responsibility of the borrower during the construction phase. These expenses are not typically handled through an escrow account but are paid directly by the borrower.

Key Differences

In a construction loan, the payment structure is based on a draw schedule tied to the progress of the project, while traditional mortgages provide the loan in a lump sum at closing. Construction loans rely on regular inspections and approvals for risk management, whereas traditional mortgages manage risk through an escrow account that handles taxes and insurance.

While construction loans do not use an escrow account, the draw schedule provides the lender with control and oversight to ensure the funds are used appropriately. Understanding this distinction helps borrowers better prepare for managing taxes and insurance during the construction phase.