The bank issuing a construction loan pays the builder the total money not in one
lump sum but in several smaller amounts (perhaps monthly) for all the work done
since the last bill was submitted by the builder. The bank usually sends out
an inspector to verify that the work the builder claims to have done has actually
been done, and also checks that the
builder has paid all his subcontractors for the work that they have done on
his behalf. (The
builder submits lien waivers from the subcontractors in which they affirm that
they have been paid). You are involved in all this since all the paperwork comes
first to you and it is you who sends it on to the bank with a request to release
the funds. So it is useful for you to check for yourself
that all the stuff that the bank is going
to check, and indeed you should check even more. If you ordered a specific
kitchen faucet and the plumbing subcontractor installed a different and
cheaper one, the bank inspector will likely not even notice: "one kitchen
faucet installed, check" but you will hear about the matter from your significant other for the rest of your life.
Thus, how much you owe the bank is an increasing amount as construction
proceeds and yes, you pay interest each month on the amount you owe. The required payment each month increases as the balance owed increases month after
monthly payments on construction loan are interest only; no part of the
principal amount is repaid.
When construction is complete and all the final inspections are done
and the city issues you a Certificate of Occupancy, you apply for a regular mortgage loan. This pays off the construction loan and you start making
regular mortgage payments. Note: you don't have to get the mortgage
loan from the same bank that issued the construction loan, but you do need
to not dawdle on this because interest rates on construction loans are
typically quite a bit higher than mortgage loan rates, and so it is in
your best interest (pun intended) to switch to a regular mortgage loan
as soon as possible.
At least, that's how things work in Illinois. People in other states
and countries might have to operate under different rules.