What are construction loans?
A construction loan is a type of bank-issued short-term financing, created for the specific purpose of financing a new home or other real estate project. A traditional mortgage, also called a permanent loan, will help you buy an existing house. However, if you need to build a new house from the ground up, especially if you also need to purchase the raw land, that’s where a construction loan can help.
The loan can be applied for by anyone who is investing their time and money in construction or related expenses. An individual homeowner, a contractor, or a small business owner can use construction loans to finance their construction project. If you already own the land, the equity that you have in that property can be used as your down payment for your construction loan.
Many borrowers ask how a construction loan turns into a mortgage. After the house is complete and the term of the loan ends (usually only one year), the borrower can refinance the construction loan into a permanent mortgage. Alternatively, the borrower can apply for a new loan (often called and “end loan”) to pay off the construction loan.
Does the borrower make monthly payments on a construction loan? Yes, however interest payments on this loan might only be required while the construction project is still underway. Unlike a lump sum loan, construction loans are similar to a line of credit, so interest is based only on the actual amount you borrow to complete each portion of a project rather than all at once. Some construction loans may require the balance to be paid off entirely by the time the project is complete.
More than just for the actual building, a construction loan can also be used to pay for equipment used in construction, building materials, or for hiring employees.
New construction: If you are an individual or small business owner who is looking for funding to build a new home for yourself or a client, then you can apply for a short-term construction loan. This type of loan can be used to pay for the construction of new buildings. Construction loans have high-interest rates owing to the risk involved.
Builders or homeowners who want to build custom homes generally look to a construction loan. After completing the project, you can refinance the loan into a mortgage, or you can repay it by taking a new loan from another financial institution.
Expect a big down payment: Construction loans generally require a large down payment of around 20-25% of the total cost of the project, usually the cost of construction and mortgage.
Thorough application process: When you apply for a construction loan, you’ll be asked to provide the details of your construction project, including like the total amount of funding required, details about the builder, a detailed project timeline, the floor plans or construction drawings, the cost of materials, and the cost of labor.. (We’ll talk about applying for a construction loan in more detail later.)
Look out for paperwork: Until recently, it was hard to find lenders offering construction loans online. If you know you want to apply for a construction loan, you might find it easiest to visit your local bank or regional credit unions and ask for information in person. These institutes will be aware of the local property and construction market, and should be able to help you create a plan for your application.
Construction Mortgage Loans: This is a loan you can use to finance the purchase of land, or construction of a home on land you already own. These loans are usually structured so that the lender pays a percentage of the completion costs and you, the builder or developer, pay the rest.
During construction, the lender will release your funds in a series of payments, called “draws.” Typically, the lender will require an inspection between draws to check that the project is proceeding as planned. As the borrower, you are responsible for paying interest on the amount of funds you use.
This is different from a term loan, where you get a lump sum payment at once, and then pay back interest on the whole amount. Once your construction is complete and your interest paid, you’re responsible for repaying the entire loan amount by the due date. Generally, construction loans have short terms because they reflect the amount of time it would take to build the project; a year-long term is common.
Construction-to-Permanent Loans: Also called the CP loan, construction-to-permanent loans are another option for financing the building of a new home. CP loans offer some extra convenience to borrowers by combining two types of loans in a single process.
During construction, if you have a construction-to-permanent loan, you only pay interest on the outstanding balance, at an adjustable rate determined by the lender and pegged to the prime rate. The prime rate is a widely-used benchmark based on the federal funds rate, which is set by the Federal Reserve, meaning that if the Fed raises rates, then the interest rate on your construction-to-permanent loan will rise, too.
When the construction phase is over, the C2P loan converts into a standard 15- or 30 year mortgage where you pay principal and interest.
An advantage of construction-to-permanent loans for small business owners and homeowners is that instead of having to get a loan for the construction phase and then a second for financing the finished project, you can get two loans at once. In this scenario, you only close once and pay one set of closing costs.
Commercial Construction Loans: If you’re thinking bigger and planning to construct a multi-family home or apartment building, high-rise, multi-unit retail center, commercial office building, or other type of larger project, then you should probably be looking for a commercial construction loan.
Lenders for modern commercial construction loans for apartments and similar big projects are extremely risk-avoidant, and will expect a developer to shoulder most of the risk by covering up to 90% of the cost of the project. If you’re involved with this type of commercial project, you’ll need to be prepared with a lot of cash on hand to fund the construction yourself.
Purchase Equipment and Materials: You can use a construction loan to buy material and equipment that will be used in the construction of the new home.
Expanding a Company’s Facility: If you are a small business owner with a physical location and you need to build a new office or remodel an existing one, then you can use construction loans to finance your construction project.
Hiring and Training Employees: You can use the funds from a construction loan to hire new employees for construction purposes. You can also finance education and training costs for those employees with your construction loan.
Overcoming Damage or Disaster Expenses: If your office or commercial property is damaged by unforeseen circumstances like an earthquake or other disaster, you can use construction loans to make necessary repairs.
Is it harder to qualify for a construction loan? Yes, construction loans are harder to get than a typical mortgage. Most lenders consider construction loans risky (because there is no asset to secure the loan), so you’ll face some stiff requirements if you decide to apply. Here’s what many lenders require for a construction loan:
Down payment: To get a construction loan, you’ll need to make a down payment of 20% or more of the cost of the total project. This means that you will need to be prepared to start the project with your own funds or assets before a lender will agree to loan more. If you already own the land, for example, it’s likely that you will be able to use that toward the down payment amount.
Talk to your lender about this. The particular amount of your down payment will depend on the cost of your project, the land, and what you plan to do with the funds. Lenders require high down payments as a way of making sure you’re invested in the project and won’t vanish if things go wrong during construction.
Strong personal credit: Anytime you apply for a construction loan, you’ll need to provide the lender with your personal credit history–even if you are applying as a small business. The lender will almost definitely want to see your personal FICO score and your business credit history, too.
Financial documents: Typically, a prospective lender will analyze your current and past debt and payment history, as well as any other loans or liens you may have on your property. Whether this loan is for your own home, or for a small business construction project, you’ll be asked to provide financial statements, tax returns, and proof of other assets.
Good reputation: Whether you are the builder, or you are working with a builder, know that the lender will scrutinize the builder’s reputation. Any public information is fair game for making this judgement call: vendor and subcontractor reviews, online reviews, and previous work history.
If you are working with a builder, they should not hesitate to provide evidence of their good reputation, along with the detailed project plans and cost estimates you’ll also need. If you need help finding a qualified builder, check out one of the many National Association of Home Builders chapters closest to you. A trusted local builder with a solid history of successfully completed projects will have an easier time getting a vote of approval from a financial institution in the form of a construction loan.
Specific plans: To qualify for a construction loan, you must have specific and detailed building plans, construction contracts, and cost estimates ready.
Appraisal: It’s challenging to appraise something that does not exist yet! Of course, there are experts who do just that every day. Construction lenders work with appraisers to analyze your project when you apply for a loan. They review the specifications of your construction project and compare it with other existing constructions of similar specifications. They then draw conclusions regarding the possible worth of the construction in the future.
It is very important to get a good appraisal to improve your chances of getting a construction loan approved. You can get an independent appraisal if you want, but your lender will most likely insist on conducting their own.
If you have less-than-perfect credit, you may qualify for a construction loan backed by the Federal Housing Administration. FHA construction loans have lower qualification minimums than most banks. As of October, 2020, these FHA requirements were: FICO® score at least 580 = 3.5% down payment FICO® score between 500 and 579 = 10% down payment MIP (Mortgage Insurance Premium ) is required Debt-to-Income Ratio < 43% The home must be the borrower’s primary residence Steady income and proof of employment
Before making decisions about your potential construction loan, we recommend that you consider a wide range of options. Banks, online lenders, brokers, and subcontractors can each help you through the difficult and stressful process of completing your construction project. On the other hand, if you choose the wrong partners, they can add delays and complexity.
Shop Around for the Right Lender: You can look around for a lender that will offer all the options that you need. Some lenders will not provide construction loans while some lenders will provide loans with limited options that you do not need. Check out your local banks and credit unions to learn what type of construction financing they offer, and which options are available to you.
A broker is a professional and expert in construction loans, and an experienced one can save you a lot of hassle. They will understand your requirements, explain to you the best options that you have given your budget, and then shop around for the right lender. They may be able to get you better rates than you can negotiate yourself. Brokers understand the financial side of the construction loan as well as the construction side and both their limitations.
Confirm the Lender’s Experience: This might sound obvious, but make sure to choose a lender with experience in construction financing. If their past experience isn’t clear, you can ask them about past construction projects they’ve financed. You can also ask for references of other developers they have helped.
Tap your network and your local community: If you’re looking for help with a construction loan, look locally. Your personal network is always a good place to look for trustworthy recommendations. If you have a good relationship with a local banker or financial institution, that is also a great place to start.
Your choice of the best bank depends on a number of factors, including your borrower profile, who offers a construction loan in the state where you live, your credit rating, and how much money you have to put down on a construction loan.