Construction Loans

A construction loan is a commercial real estate loan specifically designed for construction purposes. Most commonly, construction loans are given to developers and builders that are aiming to fund a construction project. These projects can cover any property type, ranging from homes to offices and other real estate properties. The funds from this loan type can be used for any construction-related operations: purchasing land for the property, paying contracted employees, purchasing the materials needed for construction, paying for permits and property-related inspections, among other operations.
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How Does a Construction Loan Work?

A construction loan is typically a form of short-term financing that is utilized throughout the construction period. The loan is typically structured in a similar manner to a line of credit; the borrower takes out capital in stages throughout the process, making interest payments on the loan during the loan period and paying off the principal balance of the loan at the end of the term. Interest is typically only paid on the amount the borrower has drawn down on for construction. In order to receive a construction loan, the borrower must prove that they are qualified for the loan and will be able to make interest payments in time. Additionally, lenders typically require significant cash investments from the borrower to supplement the loan amount.

Types of Construction Loans

There are several types of construction loans that can be utilized for construction-related operations and costs. Examples include: a construction-only loan, a construction to permanent loan, renovation loan, and an owner-builder loan. In order to select the correct form of financing, specific conditions such as the period of financing needed, may be considered alongside broader considerations like the detailed use of funding.

Construction-only Loan:

There are several types of construction loans that can be utilized for construction-related operations and costs. Examples include: a construction-only loan, a construction to permanent loan, renovation loan, and an owner-builder loan. In order to select the correct form of financing, specific conditions such as the period of financing needed, may be considered alongside broader considerations like the detailed use of funding.

Construction to Permanent Loan:

A construction to permanent loan is a construction loan that automatically converts into a traditional mortgage loan at the conclusion of the construction work. In some scenarios, the permanent loan will be resized based on the income generated by ther property, the increase in value, and market conditions.

Renovation Loan:

A renovation loan is a financing vehicle that allows the borrower to access a higher level of funding for renovation work. This is because rather than a traditional home refinancing, this loan allows borrowers to take out capital mirrored against the value of the property after renovations are complete.

Characteristics of Construction Loans

Construction loans are taken out for the purpose of funding a work in progress, meaning there is a chance for unexpected costs and fees throughout the cycle. These loans are higher risk by default; borrowers are betting their loan against a projected value after construction is complete.  As a result, characteristics of these loans include: a short-term length, funds received in batches as construction progresses,  high interest rates, and a higher risk profile.

If the borrower taking out the construction loan backs out of the project halfway through construction, the lender is left with a halfway complete piece of collateral. Due to this potential, rates are higher on these loans.

What Does a Construction Loan Cover?

A construction loan typically covers components such as: the cost of land, contractor labor - architects and contractors, building materials for the project itself, and the cost of permits. Throughout the construction process, there may be a need for an environmental assessment of the land, so this is another cost that the construction loan may cover. In a nutshell, a construction loan can cover all costs associated with the process of bringing a property to completion.

What Are the Requirements of Construction Loans?

Given the higher risk profile of a construction loan, there are many requirements in place for a lender to provide funding. To begin, the borrower must prove a great credit history; typically, lenders require a minimum credit score of a 680 up to a 720 in order for a borrower to qualify for a construction loan. Lenders also require enough income to pay off any current outstanding debts and the new construction loan. This portion of the approval process requires financing documentation proving your annual income.
Another requirement is a down payment of at least 20% typically; some lenders may require even more, ranging up to 30% or more of the total construction costs. Most lenders require some sort of completion guarantee or performance bond where the guarantor must complete the project at their own expense or the lender can complete the project at the guarantor’s expense. With the high-risk nature of the transaction, lenders will want to see the project and construction budget for approval purposes. This demonstrates a stable cash-flow projection to ensure that interest payments can be met.

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