Construction projects are expensive, and contractors may not always have the cash they need upfront to cover all the expenses of building a new home or commercial building. Construction loans are one financing option that allows contractors to access the materials and equipment they need to complete the project. Although the process of getting one of these loans can be complex, and you’ll have to make a significant downpayment, borrowing money for construction gives you access to the capital you need to complete projects and ultimately grow your business.
How Do Construction Loans Work?
When home buyers want to purchase an existing property, they work with a lender to take out a mortgage, also known as a permanent loan. Mortgages are often 30-year loans, with the home used as collateral.
Construction loans are considered short-term loans, since most need to be repaid within a year or when the construction is complete, whichever comes first. Anyone who is invested in the project (either time or money) can take out the loan, including the contractor, the homeowner, or the small business owner building a new commercial property. Most lenders require a downpayment of 20-25% on the project, regardless of who makes the application.
If the loan is approved, it’s not issued in a single lump-sum payment. Instead, it’s more like a line of credit, with the borrower withdrawing money from regular distributions as needed. This means that you may end up borrowing less than expected on a construction loan, since you only borrow what you need to complete specific sections of the project. Although construction loans may have restrictions on how the money can be used, unlike mortgages that can only be used to purchase existing property, the money from a construction loan can be put toward equipment, materials, land, permits, and other expenses associated with the building project.
Construction loans have much higher interest rates than traditional mortgages. Although contractors must make monthly payments, the terms of the loan may only require interest payments while the project is still in process. And because you may not borrow the full amount you were approved for, the interest is only based on how much money you accept from the bank. The entire balance is due by the time the project is completed.
Although some contractors can repay a construction loan over the course of a project, it’s more likely for these loans to be converted into other types of loans. Some contractors take out a new loan, called an end loan, to repay the remaining balance. It’s more likely, though, that the loan will be refinanced into a more traditional mortgage or permanent loan.
Types of Construction Loans
Individuals working with a contractor to build a new home have several options for construction loans.
Construction Mortgage Loans
A construction mortgage loan is a traditional construction loan where the builder pays a percentage of the completion costs and the bank pays the rest. Funds are issued via draws, and the borrower pays interest on the actual amount borrowed. These are short term loans that typically have to be repaid within a year, but they can be refinanced into a traditional 15- or 30-year mortgage. The lender will most likely conduct regular inspections of the project between draws to ensure it’s proceeding on schedule.
Home and small business owners who want to simplify the borrowing process can choose a construction-to-permanent (or CP) loan. This is essentially two loans in one: A construction loan to finance the building of the home, which converts into a traditional 15- or 30-year mortgage when construction is complete. Each loan has its own interest rate. The construction loan typically has an adjustable rate pegged to the current prime rate, and you’ll be expected to make interest payments on that loan while the project is in process.
However, once the construction is completed, the loan transitions into a mortgage, with the borrower responsible for the principal and interest. The primary advantage of this type of loan is convenience, since the home or business owner does not need to take out a new loan and doesn’t need to pay a second set of closing costs.
Commercial Construction Loans
Commercial construction loans are for larger projects, such as multi-tenant structures and commercial office buildings. These are the most challenging loans to get, and banks usually require contractors to front a significant portion of the costs — sometimes as much as 90%.
Construction Loan Requirements
Because construction loans lack the built-in collateral that comes with a mortgage, banks have stringent lending requirements for them. At a minimum, you can expect the bank to require:
- A down payment of at least 20%. Large down payments are a form of insurance for the bank; if something goes wrong with construction, you have enough investment in the project to remain involved. Although you may need the loan to purchase land, if you or the homeowner already owns the land, that can be used for some or all of the down payment.
- An excellent credit history. When you apply for a construction loan, the bank will examine both your personal and business credit history.
- Financial records. The bank’s primary concern is that you will be able to repay the loan. Therefore, they’ll want to see documentation of income and expenses, proof of a positive history of paying debts, and any information about other financial obligations, including liens, loans, or insurance claims against your existing properties. Be prepared to show tax documents, bank records, account statements, and insurance records as part of the application,
- A good reputation. You will be expected to show that you are a reputable contractor to take out a construction loan. The bank will look into your reputation using online reviews, vendor references, and licensing bureaus. You’ll be expected to provide copies of your licenses, as well as documentation showing that you carry the proper insurance coverage, including liability and bonding coverage.
- Project feasibility. Getting a construction loan also requires showing your estimates and building plans, so the bank can evaluate the feasibility of the project and compare the costs to other similar projects.
- Appraisal. Because there is nothing to appraise yet, banks will rely on your plans and estimates to determine the potential value of the project in the future.
Alternative Construction Financing Options
If you cannot qualify for a construction loan, or the terms aren’t favorable, you may be able to access funds using other financing options. These include:
- Small Business Administration loans. If your contracting company qualifies as a small business, you may be able to borrow from the SBA. You must apply with an approved lender and have a good credit history, but these loans have more flexible repayment terms, usually 5-10 years.
- Contractor Line of Credit. Contractors can apply with a bank for a line of credit, which gives them access to a pool of money when they need it. The requirements are fairly strict in terms of credit history and income, but a line of credit provides instant access to funds and you only have to pay interest on the money you borrow. Limits also tend to be low, but if you repay what you take, you can continue borrowing.
- Equipment Financing. Construction equipment is a major expense, but contractors can purchase heavy equipment from dealers and finance them through the dealership or via the manufacturer. Terms vary from 2-7 years, and the down payment amount and interest rates are often lower than other loans.
- Invoice Factoring/Financing. Invoice factoring and financing allow you to use your accounts receivable to access funds. Invoice financing involves using your unpaid invoices as proof of income and capacity to repay the debt. Lenders will offer a percentage of your receivables, with the agreement that you repay the loan when the money comes in. With invoice factoring, you sell your unpaid invoices to the factoring company, usually for about 60-85% of their value. The factoring company takes responsibility for collecting on the invoices, and you receive cash that doesn’t need to be repaid.