If you own a small construction or contract firm, you understand the mixture of excitement and market uncertainty over the past decade and the future.
As a construction company owner, faced with the challenges of seasonality, rivalry and spontaneous growth opportunities, you may also benefit from knowing the importance of having access to capital to fund your business. Construction company loans are one of the funding options you need to keep on your radar.
In this guide, we will address how construction loans operate, the types of construction loans available, common ways to use construction loans, and how to apply for a construction loan.
About Construction Loans.
A construction loan is a form of bank-issued short-term financing that has been generated for the particular purpose of financing a new home or other real estate project. A conventional mortgage, also called a permanent loan, will help you purchase an existing home. However, if you need to build a new house from the ground up, particularly if you also need to buy raw property, that’s where a construction loan can help.
The loan may be applied for by someone who spends their time and resources in building or related expenses. Individual homeowners, contractors or small business owners may use construction loans to fund their construction projects. If you already own the house, the equity you have in the property can be used as the down payment on your construction loan.
A lot of borrowers wonder how the construction loan turns into a mortgage. When the house is constructed and the duration of the loan expires (usually just one year), the borrower may refinance the construction loan to a permanent mortgage.
Alternatively, the borrower can apply for a new loan (often referred to as a “end loan”) to pay off the construction loan.
Will the creditor make monthly payments on a construction loan? Yes, but interest payments on this loan will only be needed when the construction project is still underway. Unlike a lump-sum loan, construction loans are close to the line of credit, but interest is based only on the actual amount you borrow to fund each part of the project at once.
Some construction loans which require the balance to be paid out in full by the time the project is completed. A construction loan can also be used, rather than just for the actual building, to pay for equipment used in construction, building supplies or to recruit workers.
Application of Construction Loans.
If you are an entrepreneur or a small business owner who is searching for financing to create a new home for yourself or a client, you can apply for a short-term construction loan. This form of loan may be used to pay for the construction of new buildings. Construction loans have high interest rates due to the risk involved.
Builders or homeowners who want to build custom homes usually look for a construction loan. When the project is finished, you can refinance the loan to a mortgage, or you can repay it by taking a new loan from another financial institution.
Construction loans typically require a significant down payment of about 20-25% of the overall project cost, normally construction and mortgage costs.
When applying for a construction loan, you will be asked to include details of your construction project, including the total amount of financing needed, details of the contractor, comprehensive project schedule, floor plans or construction sketches, material costs and labor costs.
Types of Loans.
Construction Mortgage Loans: This is a loan that you can use to fund the purchase of property or the construction of a house on land that you already own. These loans are usually arranged in such a way that the lender pays a portion of the completion costs and you, the contractor or the developer, pay the rest.
During construction, the lender will release the funds in a series of payments called “drawings.” Usually, the lender will request an inspection between draws to ensure that the project is proceeding as planned. As the creditor, you are liable for paying interest on the amount of money you use.
This is different from a term loan, where you get a lump sum payment at once, and then you pay back interest on the entire amount. When the building is complete and the interest paid out, you are responsible for paying the full amount of the loan by the due date. Generally, construction loans are short-term because they represent the amount of time it will take to build a project; a year-long term is normal.
Construction-to-Permanent Loans: also referred to as the CP loan, construction-to-permanent loans are another tool for funding the construction of a new home. CP loans provide some extra flexibility to borrowers by combining two types of loans in one process.
During construction, if you have a construction-to-permanent loan, you pay interest only on the remaining balance at an adjustable rate decided by the lender and at the premium rate. The premium rate is a commonly used benchmark based on the federal funds rate set by the Federal Reserve, which means that if the Fed increases the rate, the interest rate on your construction-to-permanent loan would also increase.
The advantage of building-to-permanent loans for small business owners and homeowners is that you can get two loans at once instead of having to get a loan for the construction process and then a second for funding the finished product. In this case, you can only close once and incur one set of closing costs.
Commercial Construction Loans: If you think of constructing a multi-family house or apartment building, a high-rise, multi-unit shopping center, a commercial office building, or some other form of larger project, then you should definitely be looking for a commercial construction loan.